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.
are there any ETFs that approximate “socially responsible?”
mom,
MPCT is the ticker for the iShares “MSCI Global Impact ETF” with a management fee of 0.49%: https://www.ishares.com/us/products/283378/
I know there are a number of boutique firms today offering a range of products but probably with management fees too high to make them interesting for a retail investor. iShares is relatively good about keeping management costs relatively low. Unfortunately Vanguard doesn’t have a sustainable fund yet (that I know of).
—Indy
Vanguard FTSE Social Index (available only as a mutual fund): https://personal.vanguard.com/us/funds/snapshot?FundId=0213&FundIntExt=INT#tab=1
calwatch,
That’s a good suggestion, I was assuming mom was asking about an ETF because her brokerage charges her fees to buy and sell Vanguard mutual funds. If it doesn’t then the Vanguard mutual fund would definitely be the way to go.
—Indy
[edit: see Oren’s comment below re: commission-free ETF trading versus commissions on mutual funds]
You cite Vanguard’s funds as examples of how in general lost cost passive indexed mutual funds do not distribute taxable gains. However, in Vanguard’s case, it is not just because of low costs that they do not distribute capital gains. They actually are able to funnel capital gains into the ETF shares of the same fund. This process is protected by Vanguard’s patents until 2023.
https://www.bogleheads.org/wiki/ETFs_vs_mutual_funds
That is, a low cost passively indexed mutual fund should have low turnover in general (and hence rarely distribute capital gains), but Vanguard should always be able to do better than any other company’s fund.
That aside, you know what bothers me? When people say but with the ETF, I know what price I’m going to get! With the mutual fund I never really know!
Um…why the heck do you care? You’re getting exactly $500 or whatever worth of shares with a ZERO bid/ask spread. Besides, like the argument about why are you trading frequently, why are you paying attention to the price at all?
Ugh. Sorry for the rant.
Fiby,
Thanks for sharing that, I had no idea! Those Vanguard guys really know what they’re doing…
—Indy
Several years ago I took a Finance class and one of our projects was to do a multiple regression analysis comparing a plethora of mutual funds versus an index fund for a period of over 50 years. The index fund provided the best return.
What about the fact that similar ETFs usually have a lower ER?
Jeremy,
Vanguard’s ETF’s usually have management expenses roughly in line with their Admiral share classes, which is to say, somewhat lower than the Investor shares, which means you can save a little bit of money holding ETF’s instead of investor shares while your account balance is low. I don’t personally think the amount saved offsets the risks I outlined in the post (bid-ask spreads, intra-day volatility, etc), but different folks are entitled to different opinions on that.
—Indy
VTI, VEA, VWO tend to have low bid/ask spreads.
Jeremy,
Absolutely, as I mention in the post spreads aren’t a big deal in tranquil markets. But your impulse to panic sell is going to be strongest when markets are especially volatile, and that’s when spreads are going to widen. We haven’t seen those conditions very frequently of late! But they’re certain to return, and when they do, panic-selling ETF’s is going to be even more expensive than panic-selling mutual fund shares (obviously you shouldn’t do either).
—Indy
I prefer ishares ETF funds because I’m able to buy them commission-free from fidelity and they have low maintenance fees . when I have enough money for even one share I buy another share. mutual funds often have a minimum purchase requirements. I use my credit card rewards to continually buy more shares and it’s important to me that I’m able to buy one share at a time commission-free.
Oren,
You make a very good point, which is that the investment strategy that will invariably generate the highest returns for you is the one you will actually follow!
If redeeming Fidelity rewards, then transferring the money to a checking account, then transferring the money to Vanguard is too much of a hassle for you to actually do, but buying ETF shares directly from Fidelity is a strategy you will actually follow, then you’re sure to be better off buying the ETF shares from Fidelity.
I recently rearranged my portfolio slightly, not because I think the new configuration will generate higher returns — on the contrary, I think it will generate lower returns — but because the new configuration is something I can stick with, while my previous allocation entirely to increasingly expensive large-cap US stocks was causing me indigestion. The lesson: any half-decent investment strategy will generate adequate returns, as long as you’re able to stick with it. If you can’t, you’re guaranteed to underperform.
—Indy
Is it incorrect that most ETFs have no management fees, whereas most mutual funds do have management fees, yet the mutual funds perform no better? Thus wouldn’t ETFs have a net greater return, typically? I have money in about 10 mutual funds and my adviser said I would save 2 grand plus if I dumped the mutual funds and put the money into ETFs. Money is at a Schwab account with no fees to purchase or sell mutual funds.
Lela,
Yes, that’s incorrect. ETF’s have expense ratios just like mutual funds. This is not always a “management” fees: a passive ETF isn’t “managed” (neither is a passive mutual fund) but still charges shareholders for things like managing records, handling dividend payouts, and other backend bookkeeping.
I don’t want to impugn your “advisor” but I think it’s not terribly unlikely that he is paid more the more you turn over the funds in your account. Buying and holding mutual funds generates relatively few commissions, while buying and selling ETF’s (and stocks) generates a lot of commissions.
Having said that, 10 mutual funds does seem a little excessive. Is there a reason you bought the mutual funds you did? You can stick with mutual funds but buy just 3-4 and get all the market exposure the 10 provide you (depending on which 10!). If your 10 mutual funds are all expensive actively-managed funds then your advisor may be right that you need to get out of actively-managed funds and into some low-cost passive mutual funds. But that’s an expensive/active versus cheap/passive distinction; it has nothing to do with ETF’s versus mutual funds.
—Indy
If he is buying no fee MF at Schwab, he is most likely paying the advisor a fee. The One Source program at Schwab is set up just for that purpose. The only advantage is the ability to get into closed funds and share classes that are not available to small investors. Schwab also offers no fee ETF, but they restrict trading.
Schwab does not pay broker commissions, though they do charge them to some clients. Sales charges for loaded mutual funds are much higher than stock or etf commissions, though that would not apply in this case