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(I read this previous question but would like to differentiate my question by having it focus exclusively on long term, buy and hold investing).

From my understanding, it is conventional wisdom that if a person wishes to invest in the stock market but does not have the time or aptitude to evaluate individual stocks and time the market, he should invest only in no-load, low-fee mutual index funds, using a dollar-cost averaging strategy in a buy-and-hold fashion.

The reason for no-load, low-fee, passively managed mutual index funds is because there is empirical evidence to suggest that the expenses from loaded, high fee, actively managed index funds reduce earnings to even below that of low-fee fund.

Ok great; I subscribe to this view entirely. However I was informed that I have to make another decision -- whether to invest in ETFs or index funds.

I've learned that ETFs track an index just like a mutual index fund does, except that in general they have lower expense ratios than mutual index funds, and better tax advantages. To those who say that ETFs have commision fees while mutual index funds do not, this is simply not true: If I invest in my broker's ETFs they are commission free (which I would of course do if I were to go with ETFs).

Wait a minute -- the whole reason I am supposed to invest in no-load, low-fee mutual index funds is because I diversify my investment across the whole market, obtaining the average growth or loss of the market instead of trying to beat it, while minimizing my expense ratio. But now I hear that its even cheaper for me to use an ETF which is also diversified and attempts to obtain the market average.

Why would a long time investor with the investment philosophy outlined above ever chose a mutual fund over an ETF? What am I missing here?

  • is 'mutual fund' always synonymous with 'mutual index fund' (MIF)? Or is it an umbrella term subsuming both MIF and ETF? – Zhubarb Jul 15 '14 at 16:05
  • @Zhubarb I was under the impression that a mutual fund was a category which included actively managed funds mutual funds (that do not track an index) and mutual index funds (that do), and that ETFs are in a separate category. However I think I usually hear people distinguish "mutual funds" from "[mutual] index funds" in that the former refers to actively managed, non-index funds, and the latter referring of course to passively managed index funds. – Matthew Moisen Jul 17 '14 at 19:39
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First, it's not always the case that ETFs have lower expenses than the equivalent mutual funds. For example, in the Vanguard family of funds the expense ratio for the ETF version is the same as it is for the Admiral share class in the mutual fund version. With that in mind, the main advantages of a mutual fund over an equivalent ETF are:

  • You can buy or sell fractional shares, so if you want to invest an entire year's IRA contribution (and exactly that amount) in a mutual fund, you can do so. With an ETF you have to buy an integer number of shares.
  • You can automatically reinvest distributions. Most mutual funds will allow you to have dividend and capital gains distributions automatically reinvested in the fund, or even in a different fund in the same account. Typically, an ETF will pay its distributions into your brokerage account, and you will have to reinvest them manually from time to time (in integer share counts).
  • You always buy and sell at NAV. With ETFs you buy at the ask price and sell at the bid price. These may differ from the fund's actual net asset value (NAV). For widely-traded funds the difference may be small; for less liquid funds it could be significant.

From a long-term investor's point of view, the main disadvantage of mutual funds relative to ETFs is the minimum account sizes. Especially if the fund has multiple share classes (i.e., where better classes get lower expense ratios), you might have to have quite a lot of money invested in the fund in order to get the same expense ratio as the ETF.

There are some other differences that matter to more active investors (e.g., intraday trading, options, etc.), but for a passive investor the ones above are the major ones. Apart from those mutual funds and ETFs are pretty similar. Personally, I prefer mutual funds because I'm at a point where the fund minimums aren't really an issue, and I don't want to deal with the more fiddly aspects of ETFs. For investors just starting out the lower minimum investment for an ETF is a big win, as long as you can get commission-free trades (which is what I've assumed above.)

  • 1
    Motif will let you invest in fractional shares of things, including ETFs, one of the great things about it. (Though the second one is definitely an issue - Motif doesn't support drip.) – neminem May 13 '16 at 18:33
  • For long term buy-and-hold investors the advantage that is always touted for ETFs - intraday trading - doesn't mean much, as you point out. And as you point out you can get to a point where you're in the better share classes with mutual funds, w.r.t. fees. Now, I've always heard that there are "tax advantages" to ETFs - you didn't mention anything like that - is it true in general? or even in some cases? – davidbak Jun 16 '16 at 18:30
  • @davidbak, as best I can tell, most of the talk of tax advantages is a result of conflating ETFs and index funds (e.g., writers will compare the tax payouts of index ETFs against a pool of mutual funds that includes actively managed funds). There's an argument that because ETFs trade in the secondary market other investors' selling can't generate taxable events for investors that aren't selling, but I'm skeptical that outflows are a significant source of taxable events over the long run for index mutual funds. They certainly haven't been so in my experience. – Nobody Jun 21 '16 at 14:34
  • @RPL From ETFs Creation/Redemption mechanism, this arbitrage process allows ETFs to stay closer to NAV than closed-end funds (who lack arbitrage correction abilities). See here: etf.com/etf-education-center/…. – jed Jan 23 at 20:01
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I see a couple of reasons why you could consider choosing a mutual fund over an ETF

  1. In some cases index mutual funds can be a cheaper alternative to ETFs. In the UK where I am based, Fidelity is offering a management fee of 0.07% on its FTSE All shares tracker. Last time I checked, no ETF was beating that

  2. There are quite a few cost you have to foot when dealing ETFs

    • Bid-ask spread from the market maker
    • Dealing charge from your broker

    In some cases, when dealing for relatively small amounts (e.g. a monthly investment plan) you can get a better deal, if your broker has negotiated discounts for you with a fund provider. My broker asks £12.5 when dealing in shares (£1.5 for the regular investment plan) whereas he asks £0 when dealing in funds and I get a 100% discount on the initial charge of the fund.

As a conclusion, I would suggest you look at the all-in costs over total investment period you are considering for the exact amount you are planning to invest. Despite all the hype, ETFs are not always the cheapest alternative.

  • he other problem with cheaper index trackers I they have to stick with dog shares. Active funds can sell out of problem shares eg City of London IT Avoided most of the damage from the Tesco Disaster – Pepone Nov 9 '14 at 17:27
  • > "Fidelity is offering a management fee of 0.07% on its FTSE All shares tracker. Last time I checked, no ETF was beating that". VTI has an expense ratio of 0.05%. – neminem May 13 '16 at 18:31
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http://www.efficientfrontier.com/ef/104/stupid.htm would have some data though a bit old about open-end funds vs an ETF that would be one point.

Secondly, do you know that the Math on your ETF will always work out to whole numbers of shares or do you plan on using brokers that would allow fractional shares easily? This is a factor as $3,000 of an open-end fund will automatically go into fractional shares that isn't necessarily the case of an ETF where you have to specify a number of shares when you purchase as well as consider are you doing a market or limit order? These are a couple of things to keep in mind here.

Lastly, what if the broker you use charges account maintenance fees for your account? In buying the mutual fund from the fund company directly, there may be a lower likelihood of having such fees. I don't know of any way to buy shares in the ETF directly without using a broker.

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There is little difference between buying shares in your broker's index fund and shares of their corresponding ETF. In many cases the money invested in an ETF gets essentially stuffed right into the index fund (I believe Vanguard does this, for example). In either case you will be paying a little bit of tax. In the ETF case it will be on the dividends that are paid out. In the index fund case it will additionally be on the capital gains that have been realized within the fund, which are very few for an index fund. Not a ton in either case. The more important tax consideration is between purchase and sale, which is the same in either case.

I'd say stick it wherever the lowest fees are.

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