Index mutual funds remain a popular choice for the majority of retail index investors, given the comparison of costs. However, passive institutional investors and active traders will more likely be influenced by qualitative factors found in exchange traded funds (ETFs). Like many financial decisions, it all comes down to old-fashioned dollars and cents.
Not much attention has been paid to actually quantifying the differences in explicit and implicit costs in both index funds and ETFs, according to Forbes.
Still, passive institutional investors have been using ETFs because of their flexible nature. Active traders, along with some hedge funds, purchase ETFs because they are easy to trade, like stocks. Passive retail investors utilize index funds because of their simplicity. [ETFs vs. Mutual Funds: No Contest?]
Costs of tracking an index falls into three main categories: rebalancing, cash-drag and dividends.
- First off, rebalancing due to net redemptions in index mutual funds create explicit costs from commissions and implicit costs from bid-ask spreads on underlying fund trades. ETFs are made with an innate creation/redemption design that obviates these costs. [The ETF Creation/Redemption Process Explained.]
- Secondly, index funds incur costs when holding cash to deal with the daily net redemptions. ETFs don’t have this cost due to their creation/redemption process.
- However, index funds have a clear advantage over ETFs in their dividend policy. Index funds will invest dividends immediately, whereas ETFs would hold and then distribute the cash to shareholders at the end of the quarter.
Non-tracking costs can also be divided into three categories: management fees, shareholder transaction costs and taxation.
- Because the ETFs are not responsible for the funds’ accounting, ETFs generally have lower management fees.
- Shareholder transaction costs are usually zero for index mutual funds, but ETF shareholder transaction costs come from commissions and bid-ask spreads, which is determined by an ETF’s liquidity.
- Index mutual funds need to sell securities, which triggers taxable events. ETFs don’t sell securities because of their creation/redemption process. ETFs may also reduce capital gains by transferring out securities with the largest unrealized gains as part of the redemption process. The tax process favors ETFs, but you should still consult you tax advisor for advice.
Still, the investment you will ultimately decide upon depend on the amount of cash you have on hand, your time horizon and your own judgment on the costs vs. benefits that correspond with your investments. [A Brief History of ETFs: What Are They?]
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.