Even people who prefer to invest in individual stocks often devote a portion of their portfolios to the instant diversification that is a good index fund. But on the funds side of the table, there's a pair of broad classes to choose between: your good old-fashioned mutual funds, and your newfangled fancy exchange-traded funds. But if you're trying to pick between a mutual fund and an ETF that are following the same index, which is better?
That question popped up in the Motley Fool Answers mailbag, and in this segment, hosts Alison Southwick and Robert Brokamp -- and special guest Sean Gates, a financial planner with Motley Fool Wealth Management, a sister company of The Motley Fool -- unwrap the subtle differences between them that will allow you to decide.
A full transcript follows the video.
This video was recorded on Jan. 29, 2019.
Alison Southwick: The next question comes from Brett. "I understand that ETFs are more tax-efficient than mutual funds, so it makes sense to use them in retail brokerage accounts, but assuming a mutual fund and an ETF invest in the same index and have the same expense ratios in a tax-deferred account, it seems the mutual fund is a better choice because it's easier to invest in a varying amount of cash and can be more hands-off for long-term investing. Is there another reason to choose the ETF in a tax-deferred account other than real-time trading?"
Robert Brokamp: I'll start with explaining what he means by "real-time trading." An ETF is a fund -- that's the "F" -- that trades like a stock. If it's two o'clock, the market's open, and you want to buy or sell a certain ETF, you pull up the quote from your broker, you place the order, and you're probably going to get very close to that price.
Traditional mutual funds only trade and are only valued at the end of the day after the market is closed. So if it's two o'clock and you're thinking of buying or selling an open-end mutual fund, you can pull up the quote and see what it was worth the day before, but you don't know the price you're going to get if you place that order. That is definitely a benefit of ETFs.
He talked about ETFs being more tax efficient. That's generally true, but not always true, and you can find out the tax efficiency and compare a fund to an ETF at Vanguard. You just put the tickers in the site, you click on a tab that says Taxes and you'll find the tax efficiency ratio.
Just as an example, one of the biggest ETFs, the SPDR S&P 500 -- the ticker is SPY -- is actually less tax-efficient than the Vanguard 500 traditional mutual fund, so ETFs are not always the most tax efficient.
Southwick: Can you step back and define what makes something more or less tax-efficient?
Brokamp: What Morningstar does is it calculates how much you would have lost to taxes if you held the investment in a taxable account. The difference between those two funds is small, but regardless, the Vanguard 500 mutual fund is more tax-efficient.
Sean Gates: And mutual funds are a collection of dollars that then goes to buy a series of stocks. You as an individual investor -- when you buy into that mutual fund, you might be buying into stocks that have already appreciated in value because it's already been accounted for, for all of the other investors that they have, and then they're going to distribute you a pro rata portion of the capital gains of those shares, even though you didn't participate in the growth. And ETFs do a better job -- not a perfect job -- but a better job of being more liquid in attributing individual shares to the price that you enter in because they trade intraday.
Brokamp: Right. It just varies from fund and ETF. You want to look specifically at your funds if you're buying them in a retail account. But as Brett is pointing out, he's in a tax-deferred account, so he doesn't care. He does also point out another benefit of mutual funds in the sense that if you want to invest $200 in a mutual fund, you send in the $200 and it will get invested.
With ETFs, they have a share price and you have to round up or round down. If you have $200, chances are you're not going to be able invest all of that because each share has its own price. It's like buying an individual stock. Some brokerages will let you buy partial shares of ETFs, but most won't, so that is a benefit to mutual funds.
And then finally there's commissions. To buy an ETF from a regular brokerage chances are you'll pay a commission for every purchase. That said, more and more brokerages are offering commission-free trades on ETFs. You would also want to look at how much you're going to pay for each purchase of the ETF vs. the price of a mutual fund. For most open-end index mutual funds you're probably not going to pay a commission.
The bottom line, here, for Brett is you need to look at the specific fund and the specific ETF and compare all those costs. To be honest, if it is truly following the exact same index and they have similar expense ratios, it's probably not going to make that big of a difference.
Southwick: When I hear questions like this, it makes me feel like I'm not worrying enough about how I'm investing my money.
Gates: I think you're probably in a better lane than that.
Southwick: It sounds like Brett obviously cares a lot about this, but then it makes me think, "Oh, I've never even considered if I'm being tax-efficient." Then I feel intimidated and horrible about myself.
Brokamp: You shouldn't.
Southwick: OK, thanks! Brett, you're better than me!