I understand that I sometimes come across as a bit crotchety when it comes to the early retirement blogging community. Nothing could be farther from the truth! I retired at 29 and haven’t regretted it for a day since (if Mitch McConnell manages to scrounge up 50 votes to take away my health insurance we can revisit this discussion). Anybody who advocates quitting your job and doing what you love for the rest of your life is alright in my book.
Of course, there are things that I disagree with. The idea that “graduate with the most lucrative degree you can,” “get the highest-paying job you can,” and “save as much money as possible” constitute some kind of secret insight, instead of being perfect distillations of middle-class American values (for good and ill) is a somewhat bizarre affectation.
On the other hand, there are other prejudices of the early retirement folks that I endorse whole-heartedly. One of those is the preference for mutual funds over exchange-traded funds.
It has become very fashionable to prefer ETF’s over mutual funds
You can’t open the business section of a newspaper these days without reading about exchange-traded funds. You’ll virtually always hear their virtues described using the same formula:
- they’re traded throughout the day so you can buy and sell ETF’s any time you want while markets are open, while mutual fund transactions are only settled once per day;
- unlike mutual funds, ETF’s aren’t required to distribute capital gains and losses to shareholders at the end of each year, making them more “tax-efficient” investing vehicles.
The important thing to keep in mind is that both of these statements are true. I’m not here to tell you that you can’t buy and sell ETF’s throughout the day, or that ETF’s do, in fact, make taxable capital gains distributions each year.
I just don’t care.
Why I stubbornly prefer mutual funds to ETF’s
I can boil down my preference for mutual funds over ETF’s into three main ideas.
First, low-cost passive indexed mutual funds do not, in general, distribute taxable capital gains. Here are some examples of funds you might include in a broadly diversified portfolio, if you were so inclined:
- Vanguard 500 Index Fund (VFIAX): no capital gains distributions in previous 10 years;
- Vanguard Emerging Markets Stock Index (VEMAX): no capital gains distributions in previous 10 years;
- Vanguard European Stock Index Fund (VEUSX): no capital gains distributions in previous 10 years;
- Vanguard Pacific Stock Index Fund (VPADX): no capital gains distributions in previous 10 years;
- Vanguard REIT Index Fund (VGRLX): capital gains distributions in 2007, 2008, and 2016 (so-called “return of capital” distributions may reduce your taxable basis, which is largely irrelevant in this context);
- Vanguard Global ex-U.S. Real Estate Index Fund (VGRLX): no capital gains distributions in previous 10 years.
It doesn’t make any sense to privilege one fund structure over another for a reason that doesn’t actually exist.
Second, mutual fund transactions are settled at the daily net asset value, while ETF purchases and sales have to cross the bid-ask spread existing at the precise moment of sale. This is the flip side of being “able” to buy and sell shares throughout the day. In order to buy at 11 am you have to be willing to pay what sellers are asking, and in order to sell at 3 pm you have to be willing to take what buyers are offering. In extremely liquid ETF’s during periods of market tranquility that friction will be trivial. In illiquid ETF’s and during periods of market volatility you can pay handsomely for the privilege of trading in and out of ETF’s at will.
Finally, the argument for ETF’s begs the question: what are you doing trading in and out of investments on a daily, let alone hourly, let alone minute-by-minute basis? If you had a great batting average, if you had finely-tuned instincts for when an index would tick higher and when it would tick lower, if you really could “read the tape,” you would still be crossing the bid-ask spread over and over again, and for what? I’m no fan of so-called “behavioral” economics or “evolutionary” psychology, but you don’t need to conjure up some fantasy of cheating death on the savannah to understand that the more opportunities you give yourself to fail, the more likely you are to fail. Systematically adding funds to a portfolio of low-cost passively-indexed funds (as few as possible, but no fewer), with a maximum(!) transaction frequency of once per day, is a way of methodically reducing the opportunities you have to screw up. The high liquidity and low trading cost of ETF’s isn’t a feature — it’s a recipe for disaster.