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How do you decide between investing in an ETF, vs. in a mutual fund, for the popular stock indexes? Trading costs, tax efficiency, capital gains?

6

The factors to consider:

  • Expense ratio - probably the most important, especially for long-term inverstment
  • Trading costs
  • Size of the fund (How much money is in it? Smaller ones may get discontinued)
  • Age of the fund (If it's been around for a long time, the managers can't have made any huge mistakes)
  • Liquidity of the fund (how often is it traded?)
  • Can you get a dividend reinvestment plan for it?
  • Taxes are of course always worth considering, but I doubt there will be notable difference between mutual funds and ETFs
3

What is your time horizon?

Over long horizons, you absolutely want to minimise the expense ratio – a seemingly puny 2% fee p.a. can cost you a third of your savings over 35 years.

Over short horizons, the cost of trading in and trading out might matter more. A mutual fund might be front-loaded, i.e. charge a fixed initial percentage when you first purchase it. ETFs, traded daily on an exchange just like a stock, don't have that. What you'll pay there is the broker commission, and the bid-ask spread (and possibly any premium/discount the ETF has vis-a-vis the underlying asset value).

Another thing to keep in mind is tracking error: how closely does the fond mirror the underlying index it attempts to track? More often than not it works against you. However, not sure there is a systematic difference between ETFs and funds there.

Size and age of a fund can matter, indeed - I've had new and smallish ETFs that didn't take off close down, so I had to sell and re-allocate the money.

Two more minor aspects: Synthetic ETFs and lending to short sellers. 1) Some ETFs are synthetic, that is, they don't buy all the underlying shares replicating the index, actually owning the shares. Instead, they put the money in the bank and enter a swap with a counter-party, typically an investment bank, that promises to pay them the equivalent return of holding that share portfolio. In this case, you have (implicit) credit exposure to that counter-party - if the index performs well, and they don't pay up, well, tough luck. The ETF was relying on that swap, never really held the shares comprising the index, and won't necessarily cough up the difference.

2) In a similar vein, some (non-synthetic) ETFs hold the shares, but then lend them out to short sellers, earning extra money. This will increase the profit of the ETF provider, and potentially decrease your expense ratio (if they pass some of the profit on, or charge lower fees). So, that's a good thing. In case of an operational screw up, or if the short seller can't fulfil their obligations to return the shares, there is a risk of a loss.

These two considerations are not really a factor in normal times (except in improving ETF expense ratios), but during the 2009 meltdown they were floated as things to consider.

Mutual funds and ETFs re-invest or pay out dividends. For a given mutual fund, you might be able to choose, while ETFs typically are of one type or the other. Not sure how tax treatment differs there, though, sorry (not something I have to deal with in my jurisdiction).

As a rule of thumb though, as alex vieux says, for a popular index, ETFs will be cheaper over the long term. Very low cost mutual funds, such as Vanguard, might be competitive though.

2

If you just want to track an index, then ETFs are, generally speaking, the better way.

  1. They mostly have lower fees.
  2. They are more liquid.
  • aren't mutual fund "liquid" by definition? – Sparkler Mar 27 '15 at 2:25

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