Over the years I’ve heard many advisors of all kinds claim that ETFs are a great deal cheaper, and more tax efficient, than mutual funds. Is that the case? Let’s explore.
To begin, the mutual fund industry is much older and larger than the ETF universe. In fact, according to Morningstar, there are 29,575 open-end mutual funds (all share classes) compared with 1,579 ETFs. The date of the first mutual fund is less clear. It could be as early as 1774 (in Europe) or as late as 1924 in Boston. The point is that mutual funds are much older and the number of choices is far greater than ETFs. However, are mutual funds more expensive?
Mutual funds are packaged in a variety of share classes, each with a different expense ratio. When you include the exceedingly expensive B and C share class funds, then yes, I’d say that the average mutual fund has a much higher average expense ratio than the average ETF. If your goal is to select mutual funds with a low expense ratio, then the Vanguard funds are the obvious choice. In short, the share class examined has a great bearing on the result.
Why spend so much time discussing average expense ratios? Because of all the available statistics, fees are extremely important as they pertain to performance. In general, the lower the fees, the greater the probability of outperformance.
What about tax efficiency? Isn’t this important? Absolutely. But in a practical sense, selecting funds based solely on tax efficiency is like the tail wagging the dog. It’s important, but the bottom line is the bottom line. In other words, what’s important is what you get after all fees and taxes, not before. Perhaps the best way to keep taxes to a minimum is to select index funds where the turnover ratio and taxes are low.
You could also buy the market by investing in passive index funds or you could look for talented managers with a propensity to outperform their index. In any event, here’s what we know for sure. If you buy an index fund, you’ll never beat the index, since the fund has to deduct expenses. Conversely, if you buy an actively managed fund, you may outperform its index or you may not. But at least you have a chance at it.
My personal belief is to buy some of both. I like index funds for certain categories where alpha is harder to achieve and actively managed funds where it is not. Again, I would turn to the experts at Morningstar for that analysis, as they have some excellent research into categories in which active management is more likely to succeed.