Over time, I have read many articles that aim to educate advisors on the best practices of using an ETF versus a mutual fund. Among the biggest considerations of such a decision is if an advisor plans to “trade.” Such stories typically indicate that a mutual fund would be the better choice if the advisor plans to simply buy and hold. The premise behind that notion is that if an advisor will not regularly trade the position, why buy a structure with an unneeded feature and avoid the additional costs — specifically, spreads and commissions — associated with making the initial investment in an ETF.
What this line of thinking ignores is the inherent operational and tax efficiencies that are built into the ETF structure. It can be easy to underestimate this benefit for two reasons. First, it is difficult to have a true apples-to-apples comparison in the ETF and mutual fund structure. One will not likely find an ETF and a mutual fund that are managed the exact same way and have the exact same inflows and outflows. Second, the operational and tax savings and resulting positive impact on performance returns in the ETF structure are not identified by a line item in the fee table of an ETF prospectus.
Nonetheless, overlooking the significant operational and tax benefits of the ETF structure, or not understanding their potential impact, could cause someone to quickly dismiss an ETF investment as being a good buy-and-hold investment. Thankfully, real data can provide a good estimate of the actual difference.
As an example, the Invesco Equal Weight S&P 500 mutual fund carries nearly an identical investment strategy offered by a Guggenheim ETF. Despite these similarities, the table below provides a closer look at the tax-adjusted returns provided by Morningstar (as of Sept. 30, 2015).
There are a few key items to point out. First, these two strategies are close but not exactly the same, as evidenced by the pre-tax performance numbers. For any buy-and-hold investor of the ETF, the dividend distributions of this equity strategy caused the after-tax performance returns to be less. Factoring in the cost of the trade, the closing price for the ETF on Sept. 30, 2005 was $162.77 — so assuming a .05 spread and $15.00 commission on a $10,000 transaction, there would be $18.07 of exchange-traded costs. This would add 18 basis points of cost. Based on the average annualized difference of after-tax returns, this cost would have been recovered by the performance differential in the first year. For the next nine years, the buy-and-hold ETF investors would then have witnessed demonstrably better returns.