The other day a colleague was explaining to me how he moved from a furnished apartment to an unfurnished one, which ultimately put him in the market for some furniture. I started to think that this decision is similar to one we may find ourselves making for our portfolios. I know it seems odd to relate furniture purchasing and choosing between ETFs and mutual funds, but my time as a graduate teaching assistant helped me realize just how much explanations can be enhanced by correlating otherwise unrelated concepts! Let me explain.
My colleague thought about renting furniture because there was a chance he might move back into a furnished apartment sometime in the future, yet he decided to buy instead. What factored into his decision? Ultimately it was how long he planned to stay in this apartment. He calculated that the monthly costs of renting the furniture would exceed the upfront costs of buying the furniture at some point during the time horizon.
Time horizon is an important factor when it comes to investing too, especially as it pertains to implementation costs. Once you’ve decided on a specific portfolio strategy for a client, the next step is implementation. Implementation choices include ETFs and mutual funds, which are subject to two main types of costs:
Transaction costs occur at a point in time and include things such as bid-ask spreads and upfront fees or commissions.
Ongoing costs occur gradually over time and include things such as expense ratios and taxes.
Because these costs occur at different points in time, the expected time horizon can favor one vehicle over another, not too dissimilar to the furniture-purchase decision. The figure below summarizes a hypothetical transaction cost/ongoing cost analysis for a mutual fund versus an ETF. The analysis makes a few assumptions, including that gross return expectations for both products are similar and that the transaction is a one-time purchase in which differences in return lost to taxes are not incurred (meaning expense ratio is the only ongoing cost).
Scenarios 1 and 3 yield straightforward conclusions because one product has a lower expense ratio and lower transaction costs, giving it a clear advantage over the other. In these scenarios, no break-even holding-period analysis is required.
Scenarios 2 and 4 yield a less straightforward conclusion because no clear cost advantage exists. For example, in Scenario 2, the mutual fund has a lower expense ratio but higher transaction costs. This means the mutual fund is more costly as soon as the purchase is made, but because it has a lower expense ratio, it eventually “catches up” to the ETF and becomes less expensive in terms of total costs over a specific time horizon. In these scenarios, a break-even holding-period analysis is required to determine just how long it would take one product to catch up with the other.
How to calculate the break-even holding period
TC1 – TC2
ER2 – ER1
TC1and ER1 refer to transaction costs and the expense ratio, respectively, for Product 1.
TC2and ER2 refer to transaction costs and the expense ratio, respectively, for Product 2.
How does one use the formula? For a quick tutorial, I can provide an example similar to Scenario 2 above. Let’s say Product 1 is a mutual fund and TC1 and ER1 equal 2 and 8 basis points (bps), respectively, while Product 2 is an ETF and TC2 and ER2 equal 1 and 20 bps, respectively.
The break-even holding period (in years) is:
2 – 1
20 – 8
This equals one-twelfth of a year, or roughly four weeks. In other words, the mutual fund costs more initially, but after four weeks, it costs less overall because of expense ratio savings. Thus, an investor expecting to hold this investment for more than four weeks may prefer the mutual fund to the ETF.
A more thorough review of selection considerations (and the math behind the formula) can be found in our paperChoosing between ETFs and mutual funds. Break-even analyses like this are not so different from the purchasing decisions we might make daily, where our expected time horizon can be an important factor, even when deciding between buying or renting furniture. When it comes to investing, making decisions with a time period in mind can help your clients save costs, and ultimately bring them closer to their investment goals.
I would like to thank my colleague David Kwon (the apartment hunter) for his contributions to this blog and our white paper.