Our goal is to build and manage a diversified portfolio of stocks and bonds with the lowest possible fees and the greatest possible tax efficiency. ETFs offer seven advantages over index mutual funds:
ETFs can have lower expense ratios than the lowest-cost index mutual funds. (This excludes transaction commissions and spreads, which we'll discuss next chapter.) The Barclays i-shares S&P 500 ETF, for example, charges 0.09% a year in fees, compared to about double that for the Vanguard 500 Index Fund. A diversified portfolio of index funds with a common asset allocation costs about 18% less in annual expenses using ETFs than using Vanguard index funds. (The comparison is presented in the next chapter.) A key advantage of ETFs is that since you buy them like a stock in a brokerage account, you can pick the cheapest ETFs from all those available. With index mutual funds, in contrast, you tend to be locked into a singe family of products. Vanguard, for example, does not offer its index funds via the "fund supermarkets" such as Schwab OneSource; if you want to avoid transaction fees, you have to open a Vanguard account. But keeping your portfolio with a single fund provider locks you into that provider's funds and prevents you from shopping around for the cheapest funds.
Greater tax efficiency
ETFs are more tax efficient than index mutual funds. Index mutual funds themselves are highly tax efficient compared to actively managed mutual funds. But they still make capital gains distributions, which means that investors who hold them in taxable accounts (as opposed to retirement accounts) will get hit with tax bills. In contrast, index ETFs generally make minimal or no capital gains distributions. The broader and more liquid the index, the smaller the capital gains.
Better tax management
Better and easier tax management is possible with ETFs than index mutual funds. This is a key advantage that can result in significant financial differences, particularly for large accounts. If you buy ETFs in a brokerage account that tracks tax lots and allows you to indentify tax lots for sale, you can sell ETFs with the highest cost-basis, thereby minizing taxable gains. (You can also make charitable gifts of appreciated stock funds with the lowest cost basis.) With index mutual funds, in contrast, your holdings are often reported - and can be sold - using average purchase price only, reducing your ability to realize tax losses (and give away appreciated stock). I discuss this in more detail in Turning Taxes to Your Advantage.
Easier asset allocation
You can manage your asset allocation more easily with ETFs. You can buy a basket of ETFs - stock, bond and REIT indexes - in a single online brokerage account, see all your assets in one place, and track your asset allocation. The best online brokers offer portfolio analysis tools that chart your portfolio allocation. The only way to do this with index mutual funds is if you lock yourself into a single fund family, and don't buy funds from any other providers. In theory, you could manage index mutual funds from different providers using the “Supermarkets” offered by companies like Schwab. But the problem is that Schwab charges the fund companies about 0.35% of assets per year to appear in the supermarket, and that cost is passed on to you in higher fund fees. So index mutual funds from Vanguard, for example, don’t appear in the Schwab supermarket. That means that if you want to use index mutual funds to allocate your funds among different asset classes, you’ll likely need multiple accounts, won’t be able to track your asset allocation in one place, and rebalancing assets (say from a stock to a bond fund) may involve moving funds from an account at one company to an account at another.
Easier portfolio rebalancing
You can rebalance your portfolio more easily with ETFs, as your holdings are easier to track and you can use limit orders to buy and sell funds at preset prices. Importantly, the ability to manage taxes better with ETFs (see "Greater tax efficiency" above) means that rebalancing becomes an option in taxable accounts. With index mutual funds held in a taxable account, you're often forced to "buy and hold" without rebalancing because of the tax implications of reblancing. I discuss this in more detail in How to Make Money By Rebalancing.
ETFs are transparent and cannot be manipulated. ETFs and closed-end funds are baskets of stocks traded openly on exchanges, where the bid-offer spread is publicly available and reflects current market sentiment. In contrast, mutual funds are purchased at set prices after the US stock market closes, creating the risk of legal or illegal arbitrage. This issue is particularly acute for International funds. I discuss this in more detail in the section on fund arbitrage in Why Use Closed-End Funds? in the context of closed-end foreign stock funds. But the tranparency and trading advantages apply equally to both exchange traded funds and closed-end fund versus regular, open-end mutual funds.
You can short ETFs
Selling stocks short is not recommended for most investors as it's risky, difficult and generally has no role in most portfolios. However, shorting ETFs has sound uses in some cases for experienced investors:
- Your portfolio may contain ETFs that track the broad market, but you are concerned that a particular sector has become overvalued and you want to reduce your exposure to that sector. In that case you could short the relevant industry ETF. For example, much of the 1999-2000 run up in the S&P 500 was driven by the appreciation of technology stocks, exacerbated by Standard & Poor's addition of tech stocks to the index. If you owned an S&P 500 index fund, you could have offset your rising exposure to technology stocks by shorting a technology sector ETF.
- You may want to reduce your exposure to your company or the industry you work in (see Was Peter Lynch Really Right?). A moderate way of doing this is to remove ownership of stocks in your industry from your portfolio. If your industry accounts for 10% of the US stock market, you could short your industry's ETF equivalent to 10% of the aggregate value of ETFs you own which track the broad US stock market. A more radical approach is to short more than 10% of the aggregate value of your US stock ETFs to offset some of your job exposure or stock options.