A few months ago, one of my colleagues and I participated in a webcast intended to demystify and simplify ETFs. (Areplayof that webcast is available, if youre interested.) We always invite questions before and during these events, but we never expected to get
I live and breathe ETFswhich stands for exchange-traded fundson a daily basis. Its my job, after all, as the head of ETF product management for Vanguard. But when youre immersed in something all day long, its easy to forget that not everyone understands the same details you do. The questions we received were wide-ranging, thoughtful, and eye-opening.
It occurred to us that if our webcast viewers had these questions, its likely that some of you do too. So we combed through them looking for trends and found that most fell into 1 of 5 categories. Ill do my best to answer those questions here. Ill also debunk a few myths along the way.
Were going to cover a lot of territory, but I hope you come out of this understanding that ETFs arent that complicated and can be an appropriate investment option for just about any investor.
When comparing ETFs with index mutual funds, there are only a few black-and-white differences. In most cases, youll find them more similar than not. But sometimes, it simply comes down to personal preferencein an it depends kind of way.
If you need a lower investment minimum, ETFs are for you.
ETFs can be bought for the price of 1 share, typically ranging from $50 to a few hundred dollars. Meanwhile, most index mutual funds usually require an initial investment of $1,000, $3,000, or more.
If you depend on automatic transactions, index mutual funds are for you.
Mutual funds let you put investments, exchanges between funds, and withdrawals on a set it and forget it schedule. ETFs dont. If youre over age 70½, this includes required minimum distributions (RMDs) that you may want to automate from your IRAs.
ETFs and traditional index mutual fundshave more in common than you might expect. This assumes, of course, that youre doing a fair comparison between an ETF and a corresponding index mutual fund thattracks the same index.This is especially true when youre comparing Vanguard alternativesfor example,Vanguard Total Stock Market ETF (VTI)vs.Vanguard Total Stock Market Index Fund (VTSAX)because most of our ETFs are structured as share classes of the same fund. So Ill stick with that specific comparison for a bit.
will be the same because the 2 funds track the same index and own the same underlying stocks or bonds.
will be an identical match. Keeping in mind that most ETFs follow an indexing strategy, index ETFs and index mutual funds are both designed for people who want to try to
them. This helps reduce the risk that your investments will
Debunking myth 1:Contrary to popular opinion, ETFs dont invest directly in the index (because thats not possible). Instead, ETFs and mutual funds both investdirectly in individual stocks or bonds.
are nearly the same. I say nearly because not every Vanguard ETF
has a Vanguard index mutual fund counterpart, and vice versa. For example, Vanguard doesnt currently offer any balanced ETFsmeaning, ETFs that commingle stock and bond investments. But when there are matches, they cover a wide variety of alternatives, which Ill address shortly.
is the same. You can get your money out just as quickly with either type of investment.
Debunking myth 2:Also contrary to popular opinion, ETFsarentsignificantly more difficult to buy or sell than mutual funds, even in times of hour-to-hour and day-to-day market turmoil.
is about the same. Because the vast majority of ETFs track indexesjust like index mutual fundsthey buy and sell their underlying stocks or bonds less frequently. Thats a big contributor to fewer capital gains distributions and, therefore, lower taxes.
Debunking myth 3:Youll often hear that ETFs are more tax-efficient than mutual funds. In fact, when you compareindexETFs withindexmutual funds, theyre about the same. The confusion arises whencomparing index funds with actively managed funds. Index fundsboth as mutual funds and ETFscome out on top for tax efficiency. So make sure youre comparing apples to apples.
work the same way. Both types of investments distribute dividends and capital gains that come from the funds direct ownership of individual stocks and bonds. Those distributions can then be reinvested or moved to your settlement fund to be used as income.
for both will closely reflect the prices of their underlying individual stocks and bonds.
is identical between ETF and mutual fund shares of the same fund.
Debunking myth 4:Some investors have expressed concern that theyre responsible for selecting and managing the individual stocks and bonds within an ETF. Theyre not! Just like mutual funds, ETFs are managed by experts who choose and monitor the stocks or bonds the ETFs invest in.
for ETFs and mutual funds can all be conducted through one brokerage account. The bonus? You can buy and sell every Vanguard ETF commission-free in a Vanguard Brokerage Account. (Commission-free trading of Vanguard ETFs
applies to trades placed both online and by phone.Learn more about other conditions & costs that may apply.)
Debunking myth 5: Some people think theyre responsible for finding a buyer for their ETF shares. Not true. You buy and sell ETFs through a brokerage account, with no extra work on your partsimilar to how youd trade individual stocks.
If you want more transparency into and control over the price you pay or receive when youre buying and selling shares, youll want to lean toward ETFs.
In addition to end-of-day NAVs, ETF shares are priced in real-time, based on both the supply and demand throughout each trading day and the value of the underlying stocks or bonds. Mutual funds only have NAVs, so you wont know your price until the end of the day, regardless of what time you place your trade.
The 1 difference? Your exposure toinvestment risk.
ETFs are generally less risky because they come with built-in diversification1 ETF invests in hundreds or thousands of stocks or bonds. If 1 stock or bond doesnt do well, the others are there to cushion the blow. But if you own 1 or even a small handful of individual stocks and bonds and they dont do well, your account balance will take a much bigger hit.
ETFs are easier to manage. Most of them areindex funds, with a professional portfolio manager who oversees the stocks or bonds the ETF owns. You dont have to lift a finger.
ETFs are less expensive. When you buy or sell an ETF, you pay 1 commission, regardless of how many stocks or bonds are in the ETF. When you trade your own individual stocks and bonds, you pay a commission
To be fair, there are a couple of upsides to owning individual stocks and bonds, including:
With direct stock or bond ownership, youll only be subject to capital gains when
sell your investment for more than you bought it for. But in this respect,ETFs work much more like mutual fundsin that an ETF itself could pay out an annual capital gains distribution thats potentially taxable. The bright side: Capital gains distributions are rare with ETFs. In fact, 86% of all Vanguard ETFs have had no taxable capital gains distributions in the past 5 years.*
Simply put, individual stocks and bonds dont have them. ETFs do because the ETF needs to cover its operational costs. The bright side: Vanguards average ETF expense ratio is 74% less than the industry average (Vanguard: 0.07%; industry average: 0.27%).** Thats a $20 savings for every $10,000 you invest. That may not sound like a lot, but it can add up over time.
Who are ETFs for: Buy-and-hold investors or frequent traders?
Heres a myth thats begging to be debunked: the belief that ETF real-time pricing (also known as intraday pricing) is specifically intended for market-timers and day traders. And that the availability of different order typeslimit, stop-limit, etc.encourages this behavior.
As with so many things in life, just because youcando something doesnt mean that youshouldor that youhave to.ETFs can be a valuable part of just about any investment portfolio. Buy-and-hold investors shouldnt feel pressured to change their behavior just because they choose to invest in ETFs. In fact, arecent Vanguard studyproved that, on average, Vanguard clients hold their Vanguard ETFs for about 9 years.
Just about every type! But lets take a small step back before I explain.
Before making any investment decision, you shoulddetermine your asset allocationthat is, how you divide your money among stocks, bonds, and cash. Why? Because your asset allocation will drive your overall investment performance more than anything elseincluding any specific investment choice you make.†
If youre saving for anemergency fund, it may be a good idea to put your money into a low-risk money market mutual fund. It will give you more assurance that the money will be there if you need it in a hurry. And if youre saving for college, a529 accountmight be your best bet. Most offer tax benefits such as tax deductions, tax-deferred growth, and tax-free withdrawals.
Aside from those exceptions, anyone can use ETFs to save for long- and short-term goals, regardless of age. And you can invest in them through a taxable account (such as an individual or joint account or a trust) or through a tax-deferred account (such as a traditional, Roth, or SEP-IRA).††
Then, when its time to choose which ETFs to invest in, make sure they align with your asset allocation. You can keep it simple with4 total market ETFsorcustomize your portfolioany way you like.
Last but not least, the decision to invest in ETFs doesnt have to be an all-or-nothing choice. The amount you invest in them is completely up to you. And you can hold your index ETFs, traditional index mutual funds, and even actively managed mutual funds in a single Vanguard Brokerage Account.
ETFs generally fall into 1 of these categories.
Similar to bond ETFs, atotal market stock ETFgives you the most diversification. Or you can target a specific:
ESG (environmental, social, and governance), for example.
real estate, energy, technology, or health care, for example. (But remember: Because these are less diversified, they can expose you to more risk.)
Youll get the most diversification from atotal market bond ETF. Or you can target a specific:
You can also extend beyond U.S. borders to invest ininternational stock ETFsandinternational bond ETFs. These may invest in developed markets, emerging markets, or specific regions, such as Europe or Asia. And some come with a mix of U.S. and international investments (usually named global).
Some companies promote them, but what theyre most likely offering are short-term bonds. These could provide higher yields, but they dont try to maintain the steady $1 share price of a money market fund. So be aware of the risks before you invest.
If youre familiar with index mutual funds, you probably have a better handle on ETFs than you might have thought. They come with all the things we love most about index funds: more diversification (which helps manage risk), less work, and lower costs. Which ones you choose, what percentage of your savings you invest in them well, thats all up to you.
*Source: Morningstar, Inc., as of December 31, 2018.
**All averages are asset-weighted. Industry averages exclude Vanguard. Sources: Vanguard and Morningstar, Inc., as of December 31, 2018.
†Source:Vanguards Principles for Investing Success.
††Some small-business or employer-sponsored retirement plans may have limitations.
You must buy and sell Vanguard ETF Shares through Vanguard Brokerage Services (we offer them commission-free) or through another broker (which may charge commissions). See the
Vanguard Brokerage Services commission and fee schedules
for full details. Vanguard ETF Shares are not redeemable directly with the issuing fund other than in very large aggregations worth millions of dollars. ETFs are subject to market volatility. When buying or selling an ETF, you will pay or receive the current market price, which may be more or less than net asset value.
You could lose money by investing in a money market fund. Although it seeks to preserve the value of your investment at $1 per share, it cannot guarantee it will do so. An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. The funds sponsor has no legal obligation to provide financial support to the fund, and you should not expect that the sponsor will provide financial support to the fund at any time.
All investing is subject to risk, including the possible loss of the money you invest. Diversification does not ensure a profit or protect against a loss. Fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
Bond funds are subject to the risk that an issuer will fail to make payments on time and that bond prices will decline because of rising interest rates or negative perceptions of an issuers ability to make payments. Funds that concentrate on a relatively narrow market sector face the risk of higher share-price volatility. Investments in stocks and bonds issued by non-U.S. companies are subject to risks including country/regional risk, which is the chance that political upheaval, financial troubles, or natural disasters will adversely affect the value of securities issued by companies in foreign countries or regions; and currency risk, which is the chance that the value of a foreign investment, measured in U.S. dollars, will decrease because of unfavorable changes in currency exchange rates. These risks are especially high in emerging markets.
Rich Powers is the head of ETF Product Management in Vanguard Portfolio Review Department since 2015.
He and his team are responsible for conducting surveillance of competitor products and positioning, meeting with clients and prospects to discuss Vanguards ETF lineup, publishing on noteworthy developments in the ETF marketplace and Vanguard lineup, and supporting ETF education initiatives.
For the majority of his tenure in Portfolio Review, which began in 2003, Mr. Powers was a senior member of the Fund Oversight and Manager Search team, which is responsible for identifying subadvisory partners for Vanguards active fund lineup and monitoring the firm, people, process, portfolio, and performance of Vanguard funds on behalf of the firms senior leadership team and board of directors.
Mr. Powers earned a B.S.B.A. in finance from Shippensburg University and an M.B.A. in investment management from Drexel University.
My granddaughter wants to own stock for a High School graduation present. As a long-term Vanguard investor, I thought that an ETF might be an option so she could be exposed to a bundle of stocks in a specific sector of the market at a cost of under $1,000. Specifically, I thought that an alternative energy ETF might be appropriate for her to consider. However, Vanguards Energy ETFs appear to be stuck in the older energy sectors. Are you going to offer an alternative energy or energy storage ETF soon? If not which alternative energy ETFs might one consider that I could buy through Vanguard?
A clear and concise article. One of the better Ive read that settles the myths & misconceptions on choosing to own ETFs, MFs and individual stocks.
Thank you for an informative and educational article. I will be sharing this article with our adult children and their spouses.
One key point the ETF article did not address is the spread or difference between bid and ask prices. Please explain thoroughly. For large, broad-based ETFs which I own, such as VBR, is this spread for buy and hold investors becoming so miniscule that it pales in comparison to the expense ratio?
Also, the article does not mention the pooled index funds or Collective Investrment Trusts (CIT) that may be available in ones workplace savings plan and that may have far less expense than equivalent ETFs and mutual funds.
Great article thank you. My question I presently hold Vanguard Mutual
Funds in IRA and non-IRA accounts both for 20+ years which have performed very well. Of course, annual MRD distributions from IRAs are taxable income
as are dividends and capital gains DISTRIBUTIONS made involuntarily by/from
my non-IRAs are also taxable for me. I understand and accept that my IRA
are fully taxable income to me but I am very distressed that the substantial annual Mutual Fund distributions are beyond my control. Do I understand correctly that ETFs also have involuntary annual taxable distributions? Would utilizing ETFs eliminate/diminish such annual unilateral dividend and/or capital gains taxable distributions assuming of course I make no sales/redemptions from an ETF account? How and why. Thank you.
The first section comparing ETFs and Mutual Funds has information on this that should answer your question. Assuming you are comparing similar ETF index funds with similar index Mutual funds, there is little difference. Here is what was said
Tax efficiency is about the same. Because the vast majority of ETFs track indexesjust like index mutual fundsthey buy and sell their underlying stocks or bonds less frequently. Thats a big contributor to fewer capital gains distributions and, therefore, lower taxes.
Debunking myth 3: Youll often hear that ETFs are more tax-efficient than mutual funds. In fact, when you compare index ETFs with index mutual funds, theyre about the same. The confusion arises when comparing index funds with actively managed funds. Index fundsboth as mutual funds and ETFscome out on top for tax efficiency. So make sure youre comparing apples to apples.
Distributions work the same way. Both types of investments distribute dividends and capital gains that come from the funds direct ownership of individual stocks and bonds. Those distributions can then be reinvested or moved to your settlement fund to be used as income.
I have a question on the tax efficiency of an ETF vs. an index mutual fund. Its my understanding that if redemptions occur in a mutual fund that exceed the available cash, any capital gains that occur, as a result of the sale of holdings in the fund, would be distributed to all investors in the fund on a pro rata ownership basis, regardless of whether they actually sold any shares in the fund.
Whereas, when an investor sells shares in an ETF, that is done in the secondary markets and has no impact on other investors in the ETF. Additionally, even if creation shares are redeemed, the authorized participant bears the capital gains liability because the AP does an in kind trade with the ETF of ETF shares for the underlying securities in the ETF.
Perhaps this is a bit of an academic argument because the likelihood of it happening with any frequency is not very high. I am interested in knowing if I am understanding how this works correctly. In some sort of market dislocation or crisis, it seems this would be much more likely to occur. Thanks!
John, youre absolutely correct: When a mutual fund has to sell holdings to meet redemptions, those transactions could trigger capital gains. Youre also correct that ETFs can sometimes defer those capital gains via in-kind transactions. Just remember that both ETFs and mutual funds only distribute the net gain at the end of the year. And the same transactions you mentioned could just as easily trigger capital losses, which can be used to offset gains and reduce (or even eliminate) taxable distributions to fund shareholders.
Its difficult to gauge how this might play out during a market crisis. There may be several variables for example, shareholder activity, tax-lot management, and portfolio management that dont necessarily connect a market event with a higher likelihood of capital gains distributions.
Best column I have seen on ETFs! I switched to ETFs when they first became available and can recommend them without reservation. Extremely low expense ratios, diversification, low entry points, same day executions, primarily free commissions, simplicity, etc. Whats not to like? I will take them any day over individual stocks and/or mutual funds.
Although I have never purchased any ETFs, I believe they have certainly become quite a popular way of investing for many people. For myself, the $3,000 dollar minimum for index funds at Vanguard was never a deterrent. In addition, the proliferation of both index and actively managed funds has probably helped to confuse a lot of first time investors. As a marketing mechanism, I believe the ETFs have enabled some companies to expand their sales of securities to investors, and I suspect that Vanguard, early on, had to get into the ETF business in order to defend itself in the marketplace, and offer this kind of investment as an option to its investors. Because I am basically a buy and hold investor, the ability to buy and sell a security throughout each day is not an important consideration for me.
Should you invest in something you dont understand? I have read and understood the article I am still waiting for the other shoe to drop.
Dont get it so I will stay away fro it.
Rich, good info, TY. I was confused over one statement in Clear Difference, If youre over age 70½, this includes required minimum distributions (RMDs) that you may want to automate from your IRAs. Not sure I understand what this part means, you may want to automate?
Good question, John. If you take your RMD from a mutual fund, you can schedule it in advance. This means youll automatically receive the distribution on a set schedule (on December 1 of every year, for example). You cant schedule a withdrawal (including an RMD) in advance if youre taking it from an ETF.
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