ETFs Better Than Mutual Funds For Long-Term Investors

This article is a guest contribution by Matt Hougan, IndexUniverse.com.

John Bogle is wrong: Exchange-traded funds are actually the best available tool for long-term investors. Better, by far, than mutual funds.

I had this realization the other day when I was speaking about ETFs at a symposium organized by Vanguard. Anytime I put Vanguard and ETFs together, I’m reminded of the fact that Bogle, Vanguard’s founder, dislikes ETFs with a passion rarely seen in the indexing community.

A year ago, Bogle presented data at our annual Journal of Indexes board meeting showing that the average dollar invested in ETFs dramatically underperformed the ETF itself. In other words, investors had a tendency to buy high and sell low.

Bogle’s argument was built on imprecise data, but I’m not going to reopen that. For purposes of this blog, I’m less concerned with the experience of the average investor than the experience of investors who use ETFs correctly. And for those investors, there’s no question: ETFs aren’t just equivalent to mutual funds, they’re qualitatively better.

Usually, when people make this argument, they focus on the fact that ETFs are, by and large, cheaper than mutual funds. While true in general, it’s almost irrelevant. Some institutional mutual funds have lower expense ratios than any ETF. Also, ETF investors bear additional costs in terms of commissions and bid/ask spreads, which mutual fund investors don’t pay.

On costs alone, it’s a tossup.

Where ETFs truly excel—where they are definitively superior to mutual funds—is on fairness.

When you buy a mutual fund, you’re exposed to the actions of others. For instance, if you buy shares in the Growth Fund of America, and then half of the investors in the fund decide to redeem out of their positions, you will bear the brunt of the trading costs as the fund sells stocks to meet those redemptions. If any capital gains are incurred, you will pay those gains, even though you didn’t sell a share and had no intention of exiting your position.

If, on the other hand, no one sells, but another $10 billion in investor cash comes into the fund, you have to pay your share of the costs of putting that money to work: the commissions, the trading spreads, the market impact, etc.

With ETFs, the only thing that matters is you. Outside of a small number of bond funds and a few alternative asset products—such as Vanguard’s ETFs, which share classes of broader mutual funds— existing investors are completely shielded from the actions of others either entering or exiting the ETF. No paying for other people’s commissions, no paying for other people’s market impact and, by and large, no capital-gains distributions driven by the actions of others.

Your investment return and tax profile are driven by your actions, and that’s it.

This may seem like a minor detail, but if you’re investing for 10 or 20 years, those details add up.

I understand Bogle’s concerns about ETFs. Too many people trade them way too often, racking up big costs and they often shoot themselves in the foot trying to time the market.

But the beauty of the ETF structure is that if you’re a long-term investor, none of that matters. It’s just noise.

For the long-term investor, ETFs are the fairer investment, and they should generally deliver stronger after-tax returns.

The low, low costs don’t hurt either.

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