My workday is filled with conversations about exchange-traded funds (ETFs). Some are basic, others complex, but they can all be challenging. Last week, however, I got a phone call at home that proved to be one of the more challenging conversations. It was my dad, and he wanted to know about ETFs. He’s an intelligent guy, a now-retired successful professional, and a Vanguard shareholder. Talk about needing your A game!

Dad: Jimmy, I keep reading about ETFs. What are they?
Me: They’re funds that provide diversified investment exposure to a particular market segment or strategy. For example, an ETF could invest in U.S. stocks; another might invest in bonds.

 

Dad: What could I use them for?
Me: You could use them to build your portfolio according to your asset allocation.

 

Dad: Can’t I do that with mutual funds?
Me: Absolutely. Both ETFs and mutual funds can be used to build broadly diversified investment portfolios.

 

Dad: But ETFs cost less than mutual funds, right?
Me: Well, sort of. On average, ETFs have lower expense ratios than mutual funds, but those lower costs mostly reflect the difference between indexing and active management.

 

Dad: What do you mean?
Me: Because most index funds typically cost less than actively managed funds, index ETFs and index mutual funds have expense ratios that are lower than those of active ETFs and active mutual funds. It has more to do with indexing than whether or not it’s an ETF. (My dad didn’t have the advantage of the chart below. I also did not explain that for Vanguard index funds, ETF shares possess the same expense ratio as that of Admiral Shares.)

 

Jim Rowley_Explaining ETFs chart_11.5.14

Source: Vanguard calculations using Morningstar data as of 8/31/2014.

 

Dad: So then what’s the difference between ETFs and mutual funds?
Me: Actually, not as much as everyone thinks. The two are overwhelmingly similar. The big difference is how you transact. When mutual fund investors buy and sell shares, they receive the end-of-day net asset value price. ETF investors buy and sell shares on an exchange and receive an intra-day market price, usually at the moment the order is placed.

 

Dad: OK, but I’m not a trader and I don’t jump in and out of the market, so I don’t really need to buy an ETF.
Me: Just because you can trade ETFs frequently, doesn’t mean you must trade them frequently. ETFs can be used to build low-cost, broadly diversified portfolios—even for strategic, long-term investors. However, when you do trade ETFs, you’re responsible for executing the trade properly. There are costs associated with trading ETFs, like bid/ask spreads and brokerage fees, but we can talk about that at dinner this weekend.

What I really wanted to convey to my dad was that ETFs and mutual funds are extremely similar and that ETFs are simply another way for a fund company to deliver an investment strategy—typically an indexing strategy. However, transacting in ETFs is different than it is for mutual funds. I’ll cover that in more detail in my next blog post. In the meantime, I invite you to learn more about ETFs here.

 

 

Vanguard ETF Shares are not redeemable with the issuing Fund other than in Creation Unit aggregations. Instead, investors must buy or sell Vanguard ETF Shares in the secondary market with the assistance of a stockbroker. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.