The 7 advantages of ETFs over index mutual funds

by: David Jackson

Here's the case for ETFs versus index mutual funds, taken from A Better Way to Invest:

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:

1. Lower cost.
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 suupermarkets" 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.

2. 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.

3. 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 holding are 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 How to Turn Taxes to Your Advantage.

4. 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