ETFs (exchange traded funds) and mutual funds are both composed of stocks in many different companies. There are important differences between them and because of these differences, many investors perceive ETFs as being preferable to mutual funds because ETFs have lower annual expenses and generate less tax. But if you are invested in index mutual funds, it turns out that there really is not any significant difference when it comes to either expenses or taxes. The only real difference is in the time of day that you can sell an ETF versus a mutual fund. I will argue that for the vast majority of long-term investors, the time of day you sell the investment is irrelevant and there is virtually no advantage of an ETF over a mutual fund or vice versa.
What is a mutual fund?
Most investors lack the time and expertise to research and follow individual stocks. To be successful requires careful analysis of the company’s business plan, earnings, expenses, board of trustees opinions, sales outlooks, market competitors, etc. This can turn into a full-time job when owning just a handful of stocks. Instead, most people invest in shares of mutual funds. These funds in turn invest in many different stocks with the result that the individual investor can maximally diversify investments by investing in just one fund. The greater the diversification, the lower the overall risk.
There are basically two types of mutual funds: managed funds and index funds. In a managed fund, you pay for a fund manager(s) to pick which companies will be included in the mutual fund and how much of each company’s stock to include in the fund. In an index fund, the fund simply buys stocks proportionate to their company’s presence in an index. Common indexes include the S&P 500, the total U.S. stock market, the European stock market, the total U.S. bond market, etc. Because you have to pay stock analysts’ salaries, managed funds are more expensive than index funds.
You might think: “I don’t mind paying the higher expense of a managed fund since there is a stock expert picking the best stocks to include in the fund“. However, counterintuitively, index funds actually outperform managed funds on average. There is always the occasional stock savant like Warren Buffett but most fund advisors fall far short of Buffett’s investment returns. If you have read my previous blog posts, you will know that I have long been in favor of index funds, not only for physicians but also for anyone saving for retirement. Index funds are less expensive and have a higher rate of return than managed funds.
There are two key characteristics of mutual funds that every investor should be aware of. First, every time a stock held in that fund is sold at a higher price than it was purchased, it generates capital gains with the result that most years, an investor holding a mutual fund will have capital gains reported to the IRS and will owe capital gains taxes, even if the investor did not sell any shares of the mutual fund themselves. Second, when an investor does sell shares of a mutual fund, those shares are sold at the end of the trading day, when the stock market closes.
What is an ETF?
Like a mutual fund, an ETF is composed of stocks from many different companies. The vast majority of ETFs are invested in an index (similar to an index mutual fund) and only a minority of ETFs are actively managed. For this reason, the annual expense of most ETFs (“expense ratio”) is similar to that of an index mutual fund and much less than that of a managed mutual fund. ETFs handle capital gains differently than mutual funds and tend to be less likely to incur regular annual capital gains taxes; those capital gains are largely deferred until the investor eventually sells shares of the ETF. An individual investor can buy or sell shares of an ETF anytime of the day while the stock market is open, unlike mutual funds which are only sold at the time of market closing.
ETFs have become very popular with Americans. As of December 2023, there were a total of 3,108 U.S. ETFs holding $8.1 trillion and accounting for 24% of U.S. investment company assets.
Costs, taxes, and performance of ETFs vs mutual funds
ETFs are often touted as being less expensive than mutual funds and it is true that ETFs are less expensive than managed mutual funds. But there is little difference between the expense ratios of ETFs and index mutual funds. As an example, the Vanguard Total Stock Market ETF (VTI) has an annual expense ratio of 0.03%. The Vanguard Total Stock Market Index mutual fund (VTSAX) has an expense ratio of 0.04%. Similarly, the Schwab 1000 Index ETF and mutual fund both have expense ratios of 0.03%. Thus, there is really no significant difference in cost between an ETF and its corresponding index mutual fund.
ETFs are also touted as having lower capital gains taxes (i.e., greater tax efficiency). Capital gains are incurred whenever the fund sells shares of a component stock held by that fund. Index funds tend to sell shares infrequently whereas managed funds are actively buying and selling different stocks that the fund managers think will improve the returns on the fund. Thus, managed mutual funds generate more annual capital gains than index mutual funds simply because there is more annual turnover of the individual component stocks in a managed mutual fund. Moreover, when an index fund does sell shares in stocks that are losing value, the fund can take advantage of tax loss harvesting to offset the capital gains realized from the sale of stocks that are increasing in value. At the end of the day, you will pay the same in cumulative capital gains taxes when you eventually sell shares of an ETF as you will when selling shares of a similar index mutual fund. It is just a matter of whether you prefer to pay those capital gains taxes incrementally every year that you own the fund (managed mutual funds) or when you eventually sell your shares in the fund (ETFs and most index mutual funds).
Overall, the net returns (after expenses and taxes) on an ETF are virtually identical to the net returns on a similar index mutual fund. As an example, the average annual return after taxes and expenses over the last 10 years of the Vanguard Total Stock Market Index ETF was 9.93%. The Vanguard Total Stock Market Index mutual fund return was identical, also 9.93%. Similarly, the 5-year return on the Schwab 1000 Index ETF (SCHK) after expenses and taxes was 11.30% and the 5-year return on the Schwab 1000 Index mutual fund was 11.29%.
The bottom line is that when comparing ETFs to similar index mutual funds from large investment companies, there is no difference in annual returns, expenses, or cumulative net taxes paid.
The real difference between ETFs and mutual funds: the time of day of trading
As mentioned above, shares of an ETF can be bought or sold anytime of day when the stock market is open but a mutual fund is only sold at the moment that the stock market closes at the end of the day. That gives the ETF an advantage if you need money right away and cannot wait until the following day to get it. But this is almost never the case with your own personal finance strategy – you should be drawing from your cash accounts for expenses you need to pay immediately and should not be drawing from your investment accounts. This is why every person should have an emergency fund in cash (checking, savings, and/or money market accounts), sufficient to cover 3-6 months of normal household expenses. The main reason to buy and sell investments in the middle of the trading day (as opposed to the end of the trading day) is if you think you have the wisdom to know the exact minute that the investment has reached its highest price for the day. But here’s the thing, no one is that smart. There is truth to the adage “time in the market is more important than timing the market”.
To investigate market timing to sell an ETF versus selling a mutual fund at the end of the day, I looked at the daily performance of the S&P 500 index over a 12-month period from July 11, 2023 to July 11, 2024. Every day, the S&P 500 index had an opening price, a maximum high price, a minimum low price and a closing price. The graph below shows the difference between the opening price and the closing price for every day the market was open. There is really no pattern to it. Overall, there were 141 days that the closing price was higher than the opening price, 107 days that the closing price was lower than the opening price, and 4 days that they were the same. The implication is that it is very difficult to predict at the beginning of the day where the S&P 500 index will be at the end of the day. This is why investing in stock market futures is notoriously high-risk and is more like gambling than investing.
But the past 12 months has been a particularly good year for stocks – the S&P 500 is up 26.5% over the past year. So, I next looked at the 10-years from July 11, 2014 to July 11, 2024. Overall, there were 2,517 trading days during this 10-year period. On 1,337 of these days, the closing price was higher than the opening price, on 1,157 days the closing price was lower than the opening price, and on 22 days the closing price was the same as the opening price. On average, the closing price was 0.02% higher than the opening price but the range was from 5.49% higher to 5.71% lower. The graph below shows the data from all 2,517 trading days. Once again, it is not possible to predict the closing price of the stock market from its opening price.
What about the daily market high price? If you are seeking to maximize your return on an ETF, then you should seek to sell it at the moment that the ETF hits its highest price in the middle of the trading day. From the graph below, it is clear that on most days, the S&P 500 index trades at a higher price at some time in the middle of the trading day than it is at the close of the trading day. So, if you sell your ETF at that time, you’ll have a higher return than if you sell a mutual fund at the end of the day.
The problem is that price of the S&P 500 can also be lower in the middle of the trading day than it is at closing. The graph below shows that on the vast majority of days that the stock market is open, at some time during the day, the price of the S&P 500 drops below the price that it eventually closes at.
The bottom line from this analysis is that you are just about as likely to sell your ETF in the middle of the day at a price lower than the closing price as you are to sell it at a price higher than the closing price. You can drive yourself crazy trying to time the market without coming out ahead. For this reason, there is really no advantage to investing in an ETF that you can trade anytime of the day versus investing in a mutual fund that only trades at the close of the day.
So, should you own an ETF or a mutual fund?
If the choice is between an ETF and a managed mutual fund, the ETF is better. But that is only because for the average investor, the advantage of the ETF is because it is ultimately an index fund. When the choice is between an ETF and an index mutual fund, there really is no difference and no compelling reason to choose one over the other.
When choosing an ETF or index mutual fund, it is more important to look critically at what the index is invested in. A “large cap growth index fund” from one investment company may be invested in very different companies than a fund with the same title from another investment company. Even within the same investment company, a large cap index ETF may have different holdings than the investment company’s large cap index mutual fund.
Personally, for equities, I primarily invest in total stock market index mutual funds. That gives me the broadest diversification and since it gets bought and sold at the close of the trading day, I don’t have to waste time fretting about the price of the stock market every hour. Instead, I can just enjoy my day and not worry about brief fluctuations in the market.
