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Dispatches

How Investors Should Choose Index Mutual Funds and ETFs

Using the lowest expense ratios as a method for choosing between an index mutual fund and an exchange-traded fund (ETF) is a helpful rule of thumb, but it does not always lead to higher returns for individual investors. 

by Anine Sus | November 2019

Using the lowest expense ratios as a method for choosing between an index mutual fund and an exchange-traded fund (ETF) is a helpful rule of thumb, but it does not always lead to higher returns for individual investors.

Researchers reached this conclusion after looking at the differences between passive mutual funds and ETFs and how investors should go about choosing them. They specifically considered the following factors that affect index funds’ performance: matching procedure; procedure used for handling index changes, share buybacks, cash position and inflows and outflows to the fund; income earned from security lending, if any; transaction costs; expense charges; and capital gains taxes on sales of securities.

The index mutual fund or comparable ETF with the lowest expense realized higher returns for institutional investors.

However, when the method of choosing based on the lowest expense ratio was applied to individual investors, the results were not as promising. The index mutual fund with the lowest expenses had the highest return only 58% of the time, while the ETF with the lowest expenses had the highest return 68% of the time. The reason is taxes. ETFs are more tax-efficient because of their structure. The comparatively worse tax efficiency of index mutual funds led them to be the lower-returning asset when both the highest tax bracket and a holding period of many years was assumed.

Because of this, individual investors might not be able to expect higher performance as often by choosing the index mutual fund or ETF with the lowest expense ratio. Nonetheless, the authors believe there is merit to favoring ETFs as a default strategy since ETFs with the lowest expense ratio did realize a higher return than index mutual funds and investing in ETFs is a simple strategy.

Source: “Passive Mutual Funds and ETFs: Performance and Comparison” by Edwin J. Elton, Martin J. Gruber and Andre de Souza; Journal of Banking and Finance, July 6, 2019.

Discussion

Karl from West Virginia posted over 6 years ago:

Apparently the article considered only taxable accounts when looking at returns for individual investors. Would the results have been materially different for investments in a Roth IRA, for example?


Charles Rotblut from IL posted over 6 years ago:

The difference between index ETFs and index mutual funds becomes much smaller when taxes are not an issue. You'll still have to consider commissions, which continue to exist on many mutual funds purchased through a broker. The bigger picture is simply choosing the right asset class and strategy. This will have a far bigger impact than whether or not you use an ETF or a mutual fund.


Sunny from Texas posted over 6 years ago:

Article by Elton et al. is available only by purchase.


Don Dayne from MI posted over 6 years ago:

How come your new portfolio service does not recognize the following funds which are in brokerage accounts for both my wife and myself? HPI (Hancock John Preferred Income FD SH.)? Also in my Roth IRA your portfolio will not accept BDJ (Blackrock Enhanced Equity Dividend Trust)? Please advise.


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