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    Face Off: Mutual Funds vs. ETFs

    by John Markese

    Face Off: Mutual Funds Vs. ETFs Splash image

    Exchange-traded funds (ETFs) are America’s “financial idol” at the moment, getting more financial press than just about any other financial product. Even Vanguard, the bastion of the mutual fund, is rolling out ETFs.

    No wonder individual investors have their interest piqued.

    So what do ETFs have that mutual funds don’t—and vice versa?

    Well, we can settle this debate right here when it comes to standard index funds, by far the majority of ETFs, by looking at the key factors you would examine when checking out any index fund:

    • Returns,
    • Risk,
    • Expenses,
    • Yield, and
    • Tax efficiency.

    A Portfolio Comparison

    Rather than just list all the pros and cons of mutual funds and ETFs, a comparison of portfolios, two made up solely of mutual funds and the other two solely of ETFs, might give some structure to the differences and advantages.

    Table 1 illustrates the portfolios. The aggressive and conservative mutual fund portfolios are mirror images of the ETF portfolios—the aggressive portfolios are identical in their weightings and commitments to asset classes, and the same holds true for the conservative portfolios. The individual ETFs and mutual funds in the portfolios are not intended to be completely identical to each other, but they are very similar.

    The aggressive portfolios are well diversified but their asset allocations, 90% stock and 10% fixed income, put them firmly in the aggressive category, suitable for investors with long time horizons and the ability to take on risk. Neither portfolio generates significant yield, but instead would be expected to generate capital gains over the long term.

    The conservative portfolio allocations, 60% stocks and 40% bonds, put them firmly in the conservative category, with higher yield but generating less gains.

    Here are other similarities among all of the portfolios in Table 1:

    • All of the mutual funds and ETFs are indexes; none are actively managed or enhanced indexes (for more on enhanced indexes, see sidebar article);
    • Each index is also broadly diversified, none are sector indexes;
    • All of the stock indexes are capitalization weighted (stock price times number of shares outstanding).

    [For a definition of each index referenced in Table 1, click here.]

       "Enhanced" Indexes: The Fundamental Differences

    New on the ETF scene are fundamentally weighted indexes, also referred to as “enhanced” indexes. The Wisdom Tree ETFs are the best example: One or more variables, such as dividend yield, are used to weight the stocks held in the index, rather than the traditional approach to index funds, which holds stocks in proportion to their market capitalization.

    These new funds were introduced because of a debate that rages on about the merits of capitalization-weighted versus fundamentally weighted indexes.

    Simply stated, the debate hinges on the capitalization-weighted index’s heavy emphasis at times on the largest growth stocks. An index that holds stocks in proportion to their market capitalization will automatically hold large growth stocks in the highest proportion.

    The fundamentally weighted index approach attempts to avoid this growth stock weighting, which tends to occur at market peaks (in 2000, for example).

    The arguments in favor of capitalization-weighted indexes, however, include the rebalancing issue. Capitalization-weighted indexes don’t have to be rebalanced as stock prices change over time; fundamentally weighted indexes do. And rebalancing incurs transaction costs, brokerage costs and the spread between the bid and asked prices on the stocks.

    The real test, of course, is performance. The performance of capitalization-weighted indexes has a long and actual history. Proponents of fundamentally weighted indexes have backtested performance—what they would have returned if they had been in existence over some period.

    However, backtesting will almost always uncover a superior historical approach. It is the going forward with an actual portfolio that is the real test.

    The debate will no doubt continue on.

    Returns

    From Table 1, one observation is evident: The difference in the portfolio performances of the mutual fund portfolios compared to their ETF counterparts over the three-year period from May 2004 through April 2007 is relatively small: 0.67% on average annually for the aggressive portfolios and 0.69% for the conservative portfolios. The performances of the mutual fund version of the Standard and Poor’s 500 index, Fidelity Spartan 500 Index, and the ETF version, iShares S&P 500, were just off by 0.02% annually on average over the three years.

    The differences in performance of the rest of the mutual funds and ETFs were due primarily to composition differences in the underlying indexes, and not to any inherent advantage of either the mutual fund or the ETF.

    For example, the Vanguard SmallCap Index mutual fund follows the Morgan Stanley Capital International (MSCI) U.S. Small Cap 1750 index, representing 1,750 stocks and about 12% of the value of all U.S. stocks. The iShares S&P SmallCap 600 index covers 600 stocks and represents about 3% of the value of all stocks.

    Even a mutual fund and an ETF that follow the same index may have different results due to application and sampling. Vanguard Emerging Markets Stock and iShares MSCI Emerging Markets are both tied to the MSCI Emerging Markets index. Vanguard, however, uses a sampling approach to the index and holds fewer stocks than the index and therefore does not quite match the underlying index. This difference is called tracking error. In this case, the three-year annual average return on the Vanguard Emerging Markets Stock fund was 32.21%, while the comparable iShares ETF returned 33.29% for the same period. Differences in expenses could also explain some of the variation but not in this case (as will be noted later, when expense ratio differences are scrutinized).

    There were many mutual fund and ETF alternatives to choose from in constructing similar portfolios of index funds and ETFs. iShares is an ETF sponsor with a wide variety of passive index ETFs, and the entire ETF portfolio is composed only of iShares ETFs. Similarly, the entire mutual fund portfolio could have been made up of Vanguard funds, another leader in passive indexing.

    The mutual fund portfolios and the ETF portfolios were constructed with specific cap-size segments: large cap (S&P 500), mid cap and small cap. Another choice would have been a total market index, such as the Wilshire 5000, instead of these three cap-sized indexes and readily available with a mutual fund or ETF investment vehicle.

    However, a total market capitalization weighted index is dominated by the largest stocks and tracks large stocks, making the total market index less diversified than using specific portfolio weights for each of the capitalization segments—offsetting to a significant degree one of the arguments against capitalization-weighted indexes.

    Risk

    An important ingredient in this comparison is risk. Are mutual funds or ETFs inherently different in risk?

    The simple answer is no. Risk differences of similar mutual funds and ETFs are explained by portfolio composition differences. Mutual funds and ETFs with the same portfolios should have the same risk—and they do.

    The Fidelity Spartan 500 Index fund and the iShares S&P 500 have identical one-year RiskGrades of 50. RiskGrades measure the portfolio’s volatility against the market-cap-weighted average volatility of global equities during normal market conditions, as defined by the period 1995–1999, which corresponds to a RiskGrade of 100. The one-year RiskGrades for the mid-cap and small-cap mutual funds are lower than the same cap ETFs because they cover a larger sample of cap size. Greater diversification within a market segment generally translates to lower volatility and risk.

    In the case of the emerging markets mutual fund and ETF, the sampling of stocks primarily for liquidity and ease of trading by Vanguard eliminated some of the less liquid and more volatile emerging markets stocks and lowered the risk of the fund. Since mutual funds are subject to redemption in cash by their shareholders they must remain reasonably liquid.

    ETFs, by comparison, are not subject to redemption in cash. When ETF shareholders want to liquidate positions, they simply sell their shares in the market—the “exchange traded” in ETF—just as an investor would sell a common stock.

    Expenses and Expense Ratios

    This issue does highlight a major difference between ETFs and mutual funds.

    When you buy or sell shares in an ETF, you must have a brokerage account and you will incur brokerage commissions.

    For large transactions executed through deep discount brokers, the relative expense is small. For a series of small transactions, even with a deep discount broker, the relative expense may be significant. Investors investing small amounts regularly are simply better off with no-load mutual funds on a transaction-cost basis.

    Expense ratios are a different story.

    ETFs are touted as having lower expenses than mutual funds due to their structure and how ETFs are created. And that is usually but not always the case when looking at direct comparisons of similar mutual funds and ETFs.

    With the exception of the iShares MSCI Emerging Markets ETF, the ETF expense ratios are either equal to or lower than the equivalent mutual fund. For the aggressive portfolios, the weighted average portfolio expense ratio is just about the same with the mutual fund portfolio at 0.30% annually and the ETF portfolio weighted expense ratio at 0.27%. For the conservative portfolios, the weighted average portfolio expense ratio for the ETF portfolio comes in a bit lower, at 0.19%, because of the large bond holding and the relatively lower expense ratio of the bond ETF compared to the bond mutual fund.

     

    Yield

    Although, again, there are differences in the individual yields (dividends and interest paid after expenses relative to average mutual fund or ETF value) among the mutual funds and ETFs in the portfolios, the weighted total portfolio yields are identical for the aggressive portfolios (1.7%) and close for the conservative portfolios (2.7% and 2.8%). Yield differences among mutual funds and ETFs of the same investment category are often explained by differences in portfolio composition, maturity in the case of bond portfolios, and fund expenses, which are netted against fund income.

    Tax Efficiency

    Finally, ETFs are often thought of as being more tax efficient than mutual funds, and they can be. Why?

    First of all, ETFs do not face shareholder redemptions so they are not forced to sell securities, potentially recognizing gains that must be distributed to shareholders.

    Secondly, through the process of the creation of ETFs by institutions, the cost basis of the stock held by the ETFs is increased. So when, for instance, a stock is dropped by an index and must be sold by an ETF to maintain the same portfolio as the underlying index, the cost basis on the stock sold will be generally higher than for an equivalent mutual fund.

    The three-year average tax-efficiency ratings for the mutual funds and ETFs are given in Table 1. A tax-efficiency rating of 100% implies no tax consequences.

    All relevant taxes are imposed at maximum rates to determine tax efficiency. Since these mutual funds and ETFs are all index funds to begin with, they naturally have low portfolio turnovers and high tax-efficiency ratings.

    The ETF and mutual fund portfolios have very high weighted average tax-efficiency ratings, 99% for both aggressive portfolios and 98% for both conservative portfolios.

    Just as a reminder, mutual funds and ETFs that produce higher yields naturally have lower tax-efficiency ratings. So for investors seeking yield—whether it be from an ETF or a mutual fund—lower tax-efficiency ratings are a fact of life that may translate into putting low tax-efficient investments into tax-sheltered accounts when possible.

    Mirror Images—Almost

    Are there any real differences between mutual funds and ETFs as far as individual investors are concerned?

    Setting aside the transaction cost difference for small investments, and considering only broad-based index funds, the differences are likely to be insignificant.

    For that matter, there really is no reason to separate the two. You could easily create a mixed portfolio using a combination of ETFs and mutual funds and the answers would have been the same—they are interchangeable.

    The bottom line: In the index arena, avoid getting caught up in the mutual fund versus ETF debate. Instead, concentrate on creating a diversified portfolio and applying appropriate portfolio weightings for your time horizon, risk tolerance and portfolio goals. And then turn to either mutual funds, ETFs, or a combination—it really makes no difference.

       AAII.com

    For more information on ETFs and low-load mutual funds see AAII’s “Guide to the Top Mutual Funds” (received by members each March) and “The Individual Investor’s Guide to Exchange-Traded Funds” in the October issue of the AAII Journal. Both are found in the AAII Guides area of AAII.com (www.aaii.com/guides)

    Also on AAII’s Web site, see these related articles, linked through the on-line version of this article in the AAII Journal area (www.aaii.com/journal):

       Descriptions of Underlying Indexes

    Russell MicroCap Index

    The MicroCap segment of the stock market makes up about 3% of the U.S. equity market. The Russell MicroCap index consists of the 1,000 smallest securities in the small cap Russell 2000 index and plus the next 1,000 securities. Over-the-counter (OTC) bulletin board stocks and pink-sheets stocks are excluded. The index is reconstructed annually to rid the index of stocks that have become too large.

    S&P 500

    An index consisting of 500 stocks chosen for market size, liquidity and industry group representation, among other factors. The S&P 500 is designed to be a leading indicator of U.S. equities, and it is meant to reflect the risk/return characteristics of the large-cap universe. Currently, it represents approximately 75% of U.S. equities.

    S&P MidCap 400

    The S&P Mid Cap 400 index is a measure of mid-size company U.S. stock market performance. Companies are selected for inclusion in the index by Standard & Poor's based on liquidity, appropriate market capitalization, financial viability and public float. Currently, the index represents about 7% of U.S. equities.

    S&P SmallCap 600

    The S&P Small Cap 600 index invests in a basket of small-cap equities and consists of 600 small-cap stocks. Stocks are chosen for the index based on size, financial viability, liquidity, adequate float size, and other trading requirements. The index represents only 3% of the value of the overall market.

    Lehman Brothers Aggregate Bond Index

    The Lehman Brothers U.S. Aggregate index represents the U.S. dollar-denominated, investment-grade, fixed-rate, taxable bond market. Treasury, government, corporate, mortgage-backed, asset-backed and commercial mortgage-backed bonds are included in the index.

    Lehman Brothers U.S. Universal Index

    The Lehman Brothers U.S. Universal index represents the union of the U.S. Aggregate index, the U.S. Corporate High-Yield index, the Investment-Grade 144A index, Eurodollar index, U.S. Emerging Markets index, the non-ERISA eligible portion of the CMBS index and the CMBS High-Yield index. The index covers U.S. dollar-denominated, taxable bonds that are rated either investment grade or below investment grade.

    MSCI Emerging Markets Index

    The MSCI Emerging Market index includes various emerging market country indexes. As of August 2005, the index consisted of indexes from 26 countries: Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Jordan, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, Turkey and Venezuela.

    MSCI EAFE

    The MSCI-EAFE index represents international equity. It is made of 21 MCSI country indexes: Japan, United Kingdom, France, Switzerland, Germany, Australia, Italy, Spain, Netherlands, Sweden, Hong Kong, Finland, Belgium, Singapore, Denmark, Ireland, Norway, Greece, Austria, Portugal and New Zealand.

    MSCI US MidCap 450

    The MSCI US Mid Cap 450 index represents the universe of medium-capitalization companies in the U.S. equity market. This index targets for inclusion 450 companies and represents approximately 15% of the capitalization of the U.S. equity market.

    MSCI US Small Cap 1750

    The MSCI US Small Cap 1750 index represents the universe of small-capitalization companies in the U.S. equity market. This index targets for inclusion 1,750 companies and represents approximately 12% of the capitalization of the U.S. equity market.

    FTSE Developed ex North America Index

    The FTSE Developed ex North American index consists of large- and mid-cap stocks from 24 developed countries excluding the U.S. and Canada.

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