ETFs vs. Index Mutual Funds: A Quick Comparison

Much has been made of the differences and similarities between index mutual funds and exchange traded funds (ETFs), but less has been written on which makes the most sense for investors, cost-wise.

In the summer of 2003, Leonard Kostovetsky wrote an article titled “Index Mutual Funds and Exchange Traded Funds,” published in the Journal of Portfolio Management, which quantified the differences between the two investment vehicles by comparing explicit and implicit costs, according to Investopedia.

Passive institutional investors use ETFs because of their flexibility, active traders invest in ETFs for their convenience and hedge funds utilize ETFs for their simplicity. ETFs may be easily purchased in small amounts like stocks and don’t require special documentation, special accounts, rollover costs or margin. Additionally, ETFs are exempt from the short sale uptick rule, which prevents short sellers from shorting a regular stock unless the last trade provided a price increase.

It already sounds like a compelling argument in favor of ETFs.

Costs in tracking an index

• Rebalancing. Rebalancing in index mutual funds because of net redemptions generate explicit costs from commissions and implicit costs from bid-ask spreads on the underlying fund trades. ETFs are made with an innate creation/redemption design that avoids these transaction costs.
• “Cash drag.” Index mutual funds also incur costs when holding cash to deal with potential daily net redemptions. ETFs don’t incur this cost due to their creation/redemption process.
• Dividends. Index mutual funds have an advantage over ETFs in their dividend policy. Index funds will invest dividends immediately while ETFs would accumulate the cash and distribute it to shareholders at the end of the quarter.

Non-tracking costs

• Management fees. ETF costs are lower because the funds are not responsible for the funds’ accounting – the brokerage will take in these costs for the ETF holder.
• Shareholder transaction costs. ETF shareholder transaction costs come from commissions and bid-ask spreads, which is determined by the ETF’s liquidity. [Editor's note: With Schwab and Fidelity now offering a limited number of commission-free ETFs to their brokerage customers, this difference has started to disappear.] Shareholder transaction costs are usually zero for index mutual funds.
• Taxes. The creation/redemption process eliminates the need to sell securities in ETFs. Index mutual funds need to sell securities; this triggers taxable events. ETFs may also reduce capital gains by transferring out securities with the largest unrealized gains as part of the redemption process. The tax process favors ETFs, but consult your tax advisor for advice.

In the end, which type you choose depends on how long you plan to hold the fund, how much money you’re starting out with and your own analysis of costs vs. benefits that are specific to your situation.

Max Chen contributed to this article.