Financial Planning Blog

In Part 1, we discussed the basic construction of exchange traded funds (ETFs) and how they differ from conventional mutual funds. Now let's explore some of the benefits of ETFs, and why it may make sense for you to include them in your investment portfolio. We'll also briefly touch upon the dark side of ETFs, where most individual investors should fear to tread.

For the mainstream individual investor, the potential advantages of using ETFs versus conventional mutual funds fall into four main categories:

1. Asset allocation
2. Lower fees
3. Availability
4. Tax management

Asset allocation: The biggest factor in determining of the risk and return of a portfolio is how investment dollars are allocated across different asset classes. ETFs are available to track a myriad of US and international stock and bond indexes, allowing the investor to effectively include asset classes they might otherwise ignore (e.g. international small cap stocks, micro cap stocks, emerging markets, REITs, or style indexes). It's not that exposure to these asset classes is not available through mutual funds, but the choice of low cost, passively managed mutual funds is limited once you stray from the most popular indexes (e.g. S&P 500 and MSCI EAFE international developed market index). With ETFs, the choices are abundant--maybe too much so! The goal of adding these additional asset classes it to provide you with a marginally higher expected return for a given level of risk. Or conversely, reduce the volatility (risk) of your portfolio for a given level or expected investment return.

Lower fees: At Table Rock Financial Planning we are proponents of keeping your overall cost of investing low in anticipation of keeping a larger share of market returns. This generally leads to recommending passively managed index funds from the low cost providers (most notably Vanguard, but also Fidelity, Schwab, iShares, and State Street). ETFs, because of the way they are constructed, enjoy certain efficiencies over mutual funds, and have the opportunity to pass these along in lower fees. For example, the expense ratio for Vanguard's Total Stock Market Index Fund (VTSMX-investor shares) has a low expense ratio of just 0.18%, but the comparable ETF (VTI) expense ratio is only 0.09%.

Lower fees don't just end with lower expense ratios, however. Take the case of Vanguard's new international small cap index fund which has both ETF shares (VSS) and mutual fund shares (VFSVX-investor shares). Not only is the expense ratio of the mutual fund considerably higher than the ETF, but the there is a 0.75% purchase fee and another 0.75% redemption fee for the mutual fund. (These are not sales loads, but are paid directly to the fund--presumably to compensate the existing shareholders for the expenses incurred by additions and redemptions to and from the fund.) Avoiding these purchase and redemption fees more than offsets the brokerage commissions incurred when trading the ETF. (There are other considerations here--specifically whether the ETF is traded at a discount or premium versus the fund's NAV--but, we'll leave that discussion for another day.)

Availability: Depending on where you hold you investment portfolio, you only have access to certain mutual funds--and only a subset of these funds are available with no transaction fee (NTF). Unless you are using Vanguard as your custodian, you will undoubtedly only have a small selection of low cost index funds available for no transaction fee. Since the transaction costs of trading mutual funds is generally higher than for buying and selling stocks (and ETFs), it will generally be less expensive to purchase ETFs than to buy a comparable index mutual fund and pay the associated transaction fee. For example, at Fidelity you will generally pay somewhere between $8 and $20 to purchase, say 100 shares, of an ETF on-line. However, to acquire the same dollar amount of a comparable mutual fund will cost you $75, assuming it is not an NTF fund.

Lack of NTF index funds is only part of the problem the smaller investor faces. Many of the best low cost index funds have minimum investment levels that are beyond some small investors. Fidelity has some great low cost index funds, but you need $10K to get into each fund. Vanguard generally has a $3K minimum, which is less of an issue. However, it may preclude a younger investor from allocating a small portion of her portfolio across a number of sub-asset classes that may be otherwise desirable.

Tax management: Index fund investing, whether you use mutual funds or ETFs, is more tax efficient than investing through actively managed mutual funds. Maybe you had the uniquely frustrating experience of having your actively managed mutual fund distribute taxable capital gains to you during 2008, despite the fact the fund may have declined >30% in value. In taxable accounts, index funds will distribute far fewer taxable capital gains to its shareholders since they do very little selling and realization of gains. You get to delay paying capital gains until you sell your own shares at a time you choose. ETFs, again due to their construction, are even marginally more tax efficient than regular index mutual funds. (Vanguard even has some patented methods that allow their index mutual funds to realize tax benefits from the existence of their ETFs as an alternate share class.)

ETFs can also help the investor manage and minimize their taxes by facilitating efficient tax loss harvesting. Say you have significant capital losses on index mutual funds or ETFs held in a taxable account. You would like to sell the funds and realize the losses for tax purposes, however you want to remain invested and maintain your strategic asset allocation. Due to the "wash rule" you cannot sell your funds to realize your loss and then buy the same fund back to maintain your position. You could, however, sell your current index positions and then immediately buy back into the market using marginally different ETFs. For example, you sell your S&P 500 fund and then buy an ETF tracking the MSCI 750 or Russell 1000--both large (and mid) cap indexes. You then substitute ETF tracking the MSCI 1750 or Russell 2000 for your S&P Completion Index (small cap) fund. There are many opportunities to effectively cover the market while tax loss harvesting, without running afoul of the IRS.

As you can see, ETFs can be a great tool to help you construct a well diversified, cost efficient portfolio. However, like any tool, in the wrong hands and used incorrectly there can be great harm done. For the same reasons my wife won't let me have a chainsaw, you need to be aware of some of the drawbacks and dangers of ETFs, which will be covered in Part 3.