Why a mutual fund is better than its equivalent EFT

The famous financial advisor Allan Roth commented on ETF.com and used Vanguard Total Stock Market (/VTI) as an example to illustrate why a mutual fund is better than its identical twin in ETF format.(http://www.etf.com/sections/index-investor-corner/vanguard%E2%80%99s-mutual-funds-better-its-etfs)

An ETF from Vanguard and its mutual fund are merely different share classes of the same fund. ETFs generally have low expense ratios and the same expense ratios are for every investor no matter
how many shares she or he owns. And those expense ratios are cheaper than most comparable mutual funds.

But the lowest­ cost class of mutual funds at Vanguard, the so­ called Admiral share class, have the
same annual expense ratios as any corresponding ETFs. The only catch is that an investor needs to be investing at least $10,000.

Given your brokerage firm charges no commissions on buying and selling either mutual funds or ETFs, there are 6 reasons Allan has to choose the mutual funds over the ETFs:

1. No bid/ask spread – Mutual funds trade at net asset value (NAV), while ETFs have bid/ask spreads. For example, Vanguard bid/ask spreads for the first two months of 2015 averaged 0.06 percent. While lower than the 0.32 percent spread from non­-Vanguard ETFs, buying the mutual fund eliminates this cost all together. To put it in perspective, a 0.06 percent spread represents about 1.2 years of the expense ratio of the Vanguard Total Stock Market ETF (VTI)

2. No premium or discount – You may get lucky or unlucky here, trading ETFs, but you can eliminate the risk altogether by buying the mutual fund at NAV.

3. Purchase of fractional mutual fund shares – ETFs are a bit more difficult to deal with. If, for example, you have $50,000 in cash and wanted to purchase the Vanguard Total Stock Market ETF (VTI) , you must
look up the current price, calculate the whole number of shares, and then deduct a few shares before pushing “execute,” as the price may have increased and you don’t want a negative cash position. On the other hand, with the mutual fund, the Vanguard Total Stock Market Index Fund Admiral Shares (VTSAX), you just put in a buy order for the entire $50,000, and will end up investing the entire amount by owning a fractional share.

4. Automated dollar cost averaging – For clients wanting to use dollar cost averaging, mutual funds are far superior. That’s because they can be set up on an automated basis. For example, you can have Vanguard purchase $10,000 a month of VTSAX for the next 18 months, and it will happen unless you
intervene. With ETFs, you must go in monthly to make such purchases. I’ve found that either life gets in the way, or we listen to too much financial media, and don’t typically follow through on manual dollar cost averaging.

5. Less cash drag from faster dividend reinvestment – Most brokerage firms allow you to reinvest ETF dividends (where you will end up with fractional shares), but your dividend sits in cash a bit longer since the fund pays the brokerage company, which then reinvests in those shares. With the mutual fund, the fund buys more shares directly. Elisabeth Kashner refers to the ETF delay as “drip drag,” which can
take at least four business days.

6. Tax ­free exchanges of mutual funds but not ETFs – Though investors can make tax­ free exchanges to different share classes within mutual funds, or even to ETFs, they can’t make them from ETFs to mutual funds. With $5 million, investors can generally buy institutional share classes that have lower fees than the Admiral share classes. So one could convert the Admiral share class to institutional, but not the ETF share class. Allan does have clients in this predicament, with ETF positions of more than $5 million yet with tax consequences too harsh to warrant selling to buy the lower­ cost institutional share classes.

One argument on the superiority of ETFs is that they don’t have the 60­day rule that Vanguard imposes on mutual funds. This means Vanguard will generally not allow you to buy a mutual fund that you have sold in the past 60 days. While I’m not a fan of frequent trading, there can be legitimate instances where one would need to do this.

Still, one is no worse off by starting with the mutual fund, since, in either case, one could just buy the ETF. For the most part, these six reasons are fairly minor, and investors can build a broad, low­ cost and tax­ efficient portfolio using either of these share classes.

However, making the assumption that ETFs are always better than mutual funds is flawed.