So do I take the ETF? Or the Mutual Fund?

TL;DR If my heuristic doesn’t make it blindingly obvious, it probably doesn’t matter that much.

It has been nearly 46 years since Jack Bogle successfully launched index-based investing for retail investors. Although some investors remain reluctant to place all of their assets in index-tracking funds, most investors now use them for a large portion of their assets.

In this post we’ll defer tackling the extremely important (and correspondingly complicated) questions of “which indices to buy” and “which fund company to use” and focus narrowly on whether and/or when it is preferable to invest via an ETF or via a mutual fund (assuming both are available for the same index from the same provider).

This is a question which I have been asked again and again, and although I have found some good discussions of the topic, they seem more targeted towards financial professionals and less targeted towards non-professional investors who actually need to make a decision.

Example: S&P 500 with Vanguard

To keep things concrete, let’s suppose that we’ve decided to invest in the S&P 500 Index via Vanguard. We have two options:

(a) Mutual Fund: Vanguard 500 Index Fund Admiral Shares (ticker: VFIAX)
(b) ETF: Vanguard S&P 500 ETF. (ticker: VOO)

So which is better (for us)? Since both instruments are using exactly the same strategy, the factors to consider come down to various cost and liquidity considerations (which some would argue is also kind of a cost):

(Cost 1) Ongoing fees. This is a pretty easy one. As of the most recent calculation date (Apr 29, 2021), the total expense ratio for VOO (the ETF) was 0.03%, while the total expense ratio for VFIAX (the mutual fund) was 0.04%. In this case they’re close enough that it’s a non-issue: on an investment of $100,000, the ETF costs $30/year, while the mutual fund costs $40/year.

(Cost 2) Fees to Buy/Sell. Most brokerage companies have a pretty binary policy towards mutual funds commissions: they charge little or nothing to buy/sell their own (and/or selected other) funds and a relatively/prohibitively high fee to buy/sell funds from other companies. For example, it costs nothing to buy/sell VFIAX from a Vanguard account (e.g., brokerage, IRA), but Fidelity currently charges a $75 fee for buying (or selling!) VFIAX. By contrast, trading costs for buying/selling ETFs are usually either zero (again, often the case for a broker’s own ETFs) or relatively low. If your broker is charging you more than (maximum!) $10 per trade, you should seriously consider moving to a new broker.

(Cost 3) Bid/Ask Spread. Like Stocks, ETFs generally trade at a small bid/ask spread. Usually at least one or two basis points, it can widen due to market volatility, market movements, or the liquidity of the underlying instruments within the fund/ETF (e.g., due to market opening times, though this is more of an issue for global or non-US indices). Vanguard helpfully reports a measure of the historical spreads for their ETFs here, although YMMV (especially if market volatility ramps up). Mutual funds generally execute trades once per day at the NAV (“Net Asset Value”), as determined after market close. Thus, mutual funds like VFIAX effectively trade at zero spread.

(Cost 4) Premium (or Discount!) to NAV. The whole is usually equal to the sum of the parts. But this is often not exactly true in the case of ETFs. Depending on the liquidity and volatility of the underlying securities (as well the on the structure/characteristics of the ETF), it can often be the case that an ETF trades at a noticeable (and potentially persistent) premium (or discount) to NAV. As usual, Vanguard has a good write-up on the topic here, and also provides historical info in individual ETFs (e.g., the ETF premium/discount analysis here for VOO). In this case, VOO is generally within 1–3 basis points of NAV, so it’s not a major consideration.

(Cost 5) Taxes. If you are making the investment from a taxable account, ETFs tend to be slightly more tax efficient than mutual funds. Mutual funds are sometimes forced to sell appreciated securities in order to meet a redemption from the fund, thereby creating a “taxable event” for investors. ETFs, because of the way that their shares/units are created/destroyed, do not have this problem, allowing the tax liability to be deferred. Fidelity has a good discussion here. For the vast majority of retail investors, and the vast majority of index-tracking mutual funds, this is a non-issue, but it’s worth knowing about.

(Liquidity 1). Minimum investments and increments. ETFs (like stocks) generally only trade in whole shares, which means that your investment increments are limited by the price of a single share of the ETF. As I write this in September 2021, VOO is currently trading at ca. $400 per share. Obviously if you’re investing a few thousand dollars, rounding to the nearest $400 isn’t much of a problem, but if you’re planning on investing, say, a fixed amount each month, this could add some minor operational hassle. By comparison, VFAIX (like most mutual funds) has a minimum increment of just $1. The flip side of this is that the minimum initial investment into VFIAX is currently $3,000, so if you’re looking to invest less than that, your only choice is the ETF.

(Liquidity 2). Liquidity in a Crisis. Some proponents of ETFs argue that they are more liquid than mutual funds in a crisis as you can sell an ETF “instantly” and a mutual fund provider can decide to suspend redemptions (as many hedge funds did during the 2008 financial crisis). Having lived through a few cycles of market manias, panics, and crashes — which nicely correlates with the increasing number of gray hairs on my head — I personally take a somewhat more jaundiced view and would call it a draw as ETFs are potentially subject to trading halts.

Simple Heuristic

Too many factors? Here’s my simple heuristic:

• If one of the instruments has an expense ratio at least 5 basis points cheaper than the other, it gets one point.
• If one of the instruments has an expense ratio at least 20 basis points cheaper than the other, it gets an additional 2 points.
• If your current broker setup makes you pay a commission to buy the mutual fund and you consider it a hassle to set up a new brokerage account which would be commission-free, the ETF gets one point.
• If either the current or typical bid/ask spread on the ETF is more than 3 basis points, the mutual fund gets one point.
• If the ETF is trading at a premium (or discount) to NAV of more than 10 basis points, then stop, figure out why, and potentially reconsider investing in this index at all.
• If you’re holding it in a taxable account and plan to hold it for at least five years, the ETF gets one point.
• If you’re planning to add to the investment on a more-frequently-than-annual basis, the mutual fund gets one point.

Go with whichever instrument has more points. In the case of a tie, flip a coin.

Final Note: “Stop-Loss” Orders and ETFs are a Very Risky Combination

In case you decide to invest via an ETF, you should be aware that it can be an extremely bad idea to put a so-called “stop-loss order” in place that will automagically sell your shares in the event that an ETF drops below a certain threshold. You can read more here and here, but the basic problem is that ETF prices can sometimes do weird things (especially intra-day, e.g., the “flash crash”) and far from protecting investors, these strategies can generate substantial losses.

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Note: This disclaimer was shamelessly copied from an old acquaintance of mine, Chris DeMuth Jr. His blog can be well worth reading.