We received a lot of great comments and questions following my blog on the conversation I had with my dad about ETFs. For that, let me say “thank you.” As it turned out, many of your inquiries were similar to those put forth by my dad when I saw him in person. Instead of revisiting our dialogue, I’ll summarize it with what could best be described as “ETFs, ETC.”
I emphasized some factors that help investors to determine when an ETF might be preferable to a mutual fund, including expense ratios, transaction costs, and circumstances. This list isn’t exhaustive, but I think it provides a good basis for making a decision.
(E)xpense ratios My dad and I covered this at length during our phone chat. Tying back to the chart on the first blog, I did clarify with him that not every index mutual fund has a lower expense ratio than that of an index ETF. For example, Vanguard mutual fund Investor Shares have higher expense ratios than their corresponding ETF Shares.
(T)ransaction costs These costs are applicable when shares of an ETF or a mutual fund are bought and sold. For example:
1. The bid/ask spread is the difference between the highest price a buyer is willing to pay (bid) for a security and the lowest price a seller is willing to accept (ask or “offer”) for that security. If an ETF had an offer price of $100.02 and a bid price of $99.98, the bid/ask spread would be $0.04. ETFs are subject to bid/ask spreads—mutual funds are not.
2. Upfront fees may or may not apply in various situations, but they have the same effect. They take a chunk of your money right off the top!
a. Mutual funds can be subject to loads and ticket charges. Loads are a percentage of the amount invested that is charged by the mutual fund. Ticket charges are fixed dollar costs that are sometimes charged by investment account providers to process buys or sells of mutual funds. Investors who buy Vanguard mutual funds at other brokers or investment account providers may be subject to ticket charges.
b. ETFs can be subject to brokerage commissions. They’re fees charged by a broker-dealer or brokerage account to make a trade in an ETF. Whether or not an ETF is subject to a brokerage commission depends on the ETF itself and the brokerage account where it’s traded.
3. Premium/discount is the difference between the ETF’s market price and the value of the securities in its portfolio. Because secondary market transactions occur at market prices, you may pay more than the value of the underlying securities when you buy ETF shares, and receive less than the underlying securities’ value when you sell those shares. Because an ETF can issue new shares and redeem existing shares, its market price usually stays pretty close to the value of the underlying securities.
(C)ircumstances Circumstances could influence why an index ETF might be selected over an index mutual fund, including:
- Availability. An ETF might represent the lowest-cost index fund choice to some investors. Some investment account providers don’t offer various index mutual funds, including ours.
- Choice. There’s a larger number of indexing investment strategies in ETF form than there are in mutual fund form. I’m not saying that all of these strategies are worthwhile; I’m just saying there are more from which to choose.
- Frequent trading restrictions. Investors who sell shares of some mutual funds might not be permitted to buy back into the same fund within a specified time period. Even if you aren’t actively trading mutual fund shares, the “rainy day” need for your money does sometimes appear in the forecast.
- Minimum investment. Investors could buy as little as one share of an ETF. Mutual funds tend to have minimum investment amounts; for most Vanguard funds it’s $3,000.
I reiterated to my dad that the choice between index ETFs and index mutual funds should be made in the context of his overall portfolio and that they are not mutually exclusive. Both are good options, but only he knows which is ultimately better for him. I hope our “ETFs, ETC” conversation helps him feel more educated on the topic.
- Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and 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.
- All investing is subject to risk, including possible loss of principal.