ETFs vs. index funds

[Brad243480]

This might be a very amateur question...but what is better, VTSMX or VTI?  Or, more generally, are index funds or ETFs better?

Thanks.

[rickb]

This might be a very amateur question...but what is better, VTSMX or VTI?  Or, more generally, are index funds or ETFs better?

Many people only look at the difference in the management fees and conclude the ETF is "better" (ever so slightly cheaper). 

A better question is -  how are they different?

Open ended mutual funds create and redeem shares by buying and selling stocks based on purchase and redemption requests they receive, holding some amount of cash to enable the fund to honor these requests without necessarily buying and selling stocks every day.  The NAV of the fund is computed every day using the closing prices of the stocks it owns, and it is this NAV that shareowners pay when they buy or receive when they sell.  You deal with the fund directly when you buy and sell, or indirectly through a brokerage.  Many funds (nearly all Vanguard funds) can be bought and sold with no transaction fee, although if you buy or sell through a brokerage rather than directly dealing with the fund the brokerage may add its own transaction fees.  Since mutual funds are not stocks, you can't do things like create trailing stop orders or buy/sell at intraday prices.

ETF shares are continuously traded at auction (like an individual stock) at a price that is usually closely related to the price of the stocks the ETF owns, however unlike a mutual fund the price and the NAV can be different.  Shares are created and redeemed only by designated market makers, who directly buy and sell stocks in batches which they then turn into and buy and sell as shares of the ETF.  If the current price exceeds the NAV, the market maker can make money by creating new shares.  If the price is less than the NAV, the market maker can make money by redeeming existing shares.  It is this activity by the market maker that keeps the price and the NAV relatively close.  Individuals buy and sell ETFs through a broker (like a stock), so you pay whatever transaction fees you would for buying and selling stock.  Since ETFs trade like stocks, you can create trailing stop orders and buy/sell at intraday prices.

Specifically comparing VTSMX vs. VTI - these are different share classes of the same underlying fund.  VTSMX is available directly from Vanguard for no fee.  VTI is bought/sold through a broker for whatever fee the broker charges.  The management fees are slightly different (slightly lower for VTI).

The "flash crash" a few months ago provides an interesting comparison.  It had much less effect on VTSMX.  The closing prices that day had (by and large) bounced back to "normal".  VTI was briefly bought/sold at pennies on the dollar relative to its NAV.  Although the truly ridiculous trades were canceled, if you had a trailing stop on VTI at (say) 10% below its current price you were likely stopped out that day.

I don't know whether Browne commented on ETFs vs. funds, but I suspect he would have favored funds since they're quite a bit simpler.  The basic tradeoff is mutual funds are priced only once a day at closing prices (no intraday pricing) but the NAV matches the prices of the underlying stocks vs. ETFs are priced continuously but have the potential for the price to be disconnected from the NAV (as happened during the flash crash). 

[Brad243480]

Thanks a lot, Rick.  That was a very informative and helpful post.

[MeDebtFree]

VTI is bought/sold through a broker for whatever fee the broker charges.

Note that Vanguard brokerage clients can trade Vanguard ETFs commission-free 

[Reido]

I currently own ETF's, because I don't have enough money invested to gain from some of the advantages of the funds.

Since you are speaking of Vanguard funds, I own a couple vanguard ETF's myself.  The ETF's I have found will generally have lower management fees than the investor shares of the mutual fund.  If you have a larger amount of money to invest, however, you can purchase "Admiral Shares" which appear to have fees closer to those of the ETF's.  Also, the funds can utilize automatic dividend reinvestments to help get a little more yield out of your stock and bond funds.

Hope this helps...

[KevinW]

I don't know whether Browne commented on ETFs vs. funds, but I suspect he would have favored funds since they're quite a bit simpler.  The basic tradeoff is mutual funds are priced only once a day at closing prices (no intraday pricing) but the NAV matches the prices of the underlying stocks vs. ETFs are priced continuously but have the potential for the price to be disconnected from the NAV (as happened during the flash crash). 

I don't remember him every commenting on ETFs specifically, but he did advise buying mutual funds directly from their issuer (e.g. Vanguard) rather than through a broker.  By inference I think he'd advise funds over ETFs.  Browne was concerned with counterparty risk and wanted to minimize the number of people and pieces of paper between the investor and the asset.  Every moving part in there is an opportunity for errors or shenanigans.  When you buy shares of a fund directly from the issuer, you hand cash over to them, and they use that cash to buy assets.  With an ETF there is added counterparty risk from your brokerage and the market makers.  In general those mechanisms work smoothly and I'm comfortable using them, but all things being equal I prefer mutual funds.

rickb's explanation of the "flash crash" is an excellent example of an unlikely-but-not-impossible instance of counterparty risk.

[murphy_p_t]

this article, although long, gets into some of the potential counterparty-risk (perhaps) inherent using ETFs vs using a mutual fund (or owning gold & 30 year bond directly)

http://revolutionarypolitics.com/?p=5240

after reading this thread, i will have to give some thought to changing from VTI to the equiv mutual fund.

does anyone know if this change (from VTI to equivalent mutual fund - VTSAX) can be made without being a taxable event?


i just checked the vanguard site.  VTI, VTSMX, VTSAX all indicate the same Fund total net assets of $161.6 billion...I'm thinking they combine everything together?

Is all my concern moot just so long as i don't sell @ the bottom of another "flash crash"?

Another reason to use mutual funds is that there is less temptation to look at it throughout the day, same as owning the 30 year bond directly.



As an aside, I don't think that GLD can be disparaged sufficiently. I don't feel that the warning against using GLD can be strong enough! Even tracking annual performance of gold based on GLD gives that charlatan too much respect. GLD is suspect from head to toe.

[AdamA]

does anyone know if this change (from VTI to equivalent mutual fund - VTSAX) can be made without being a taxable event?


i just checked the vanguard site.  VTI, VTSMX, VTSAX all indicate the same Fund total net assets of $161.6 billion...I'm thinking they combine everything together?

If I made a move every time I got nervous about something like this, I'd be constantly buying and selling different ETFs or mutual funds (or whatever) and it would get expensive.  I think the better idea is to open a brokerage account at another firm, buy into a total market mutual fund there, and then maybe sell off some VTI in the future, when it's time to rebalance. 

That gives you some brokerage diversity and will prevent you from doing anything too rash.  Take a week to think about it before you do anything...you'll be surprised at how your perspective will change in a week. 

The risk of VTI failing on you is real but remote.  The risk of monkeying around with your porfolio an costing yourself money in the form of taxable events and fees is real and much more likely...take it from someone who knows.

[MediumTex]

Adam,

Are you surprised that someone named "murphy" would be concerned that if anything can go wrong, it will?

murphy,

To your criticism of GLD, what do you make of it trading in lockstep with IAU?  Do you think both ETFs are identically fraudulent, and thus the market values them the same in relation to gold?  I've always thought that if either fund was not legitimate, the market would know (one way or another) and one fund would get a premium compared to the other.  So far, this hasn't happened.

With that said, bullion is obviously superior to any ETF, but I think a little ETF gold isn't a bad move (especially in an IRA), all things considered.

To anyone's knowledge, has any ETF ever failed because it didn't actually hold the assets it claimed to in its audited financial statements?

[AdamA]

Adam,

Are you surprised that someone named "murphy" would be concerned that if anything can go wrong, it will?

Ha!  Guess that makes sense.

To your criticism of GLD, what do you make of it trading in lockstep with IAU?  Do you think both ETFs are identically fraudulent, and thus the market values them the same in relation to gold?  I've always thought that if either fund was not legitimate, the market would know (one way or another) and one fund would get a premium compared to the other.  So far, this hasn't happened.

I agree with you completely on the above, and feel like this whole gold ETF debate tends to border on the overly paranoid, but...

To anyone's knowledge, has any ETF ever failed because it didn't actually hold the assets it claimed to in its audited financial statements?

...ETFs are relatively new, especially commodity ETFs, so who knows. 

I think the key is to diversify like you said...a little of both physical gold and paper gold. 

[murphy_p_t]

MT,

Thank you for asking. I will list some of my concerns about the ETF GLD. Aside from the possible risk of GLD being an ETF (potential problems with ETFs are referenced above & in the article linked), I have many concerns which revolve around the operator, JPMorgan.

-appears to have close relationship with the Fed / US Government. As such, they have a vested interest in keeping down metal prices in order to maintain some credibility of Fed Res Notes
-GATA & others have been attempting to prove their activity to short metals. In fact, this link is a study unto itself (I've only skimmed it)
http://www.gata.org/node/8388

-popular resistance campaign against JPM (look up Max Keiser, admittedly a provocateur). Its probably just coincidence, but shortly after Keiser launched his “Crash JPMorgan”? campaign, silver price took off (end of last summer)
-is JPM selling metals short, like Goldman was selling short real estate paper? (does JPM offer any disclosure to its activities which relate to the metals?) for instance, see this troubling article https://marketforceanalysis.com/article ... 40611.html
-if JPM goes the way of Bear Stearns, who has first claim on that bullion?
-JPM is in trouble http://www.moneyandmarkets.com/fdic-903 ... do-2-41274

Regards IAU, guess who the custodian is? If you guessed JPM, you would be correct!
http://us.ishares.com/content/stream.js ... cation/pdf

I would contrast the JPM offering with something like Sprott (PHYS). I have a percentage, for re-balancing & speculation purposes in my Roth IRA. Although I haven't investigated it as fully as I may wish to in the future, I am reasonably confident that the metal is there, in unencumbered form. I am not aware of any reason to be concerned that Sprott has an conflicts of interest. In fact, increasing metal prices seem to be a cornerstone of his business model. I like the geographic diversification, not only of the metal itself, but also that the operation is outside the USA. Also, unitholders have the option to redeem shares in bullion, unlike GLD shareholders.

http://www.sprottphysicalgoldtrust.com/ ... fault.aspx


For those of more knowledgeable, is the fact that Sprott is a closed-end fund an advantage over an ETF?


To wrap up, I guess I could be charged as being a gold bug. I have spent countless hours following the metals. I have yet to come across anything negative about Sprott. There are just too many troubling concerns w/ JPM for me to want to touch them with a 10 ft pole.

If anyone knows of any negatives about Sprott, please let me know. My due diligence of Sprott is not very thorough.


I hope this justifies why I feel that it is a dis-service to all investors who come across this site to see any shelter given to GLD. In fact, I'm going to post this in the gold thread so that it gets the attention I feel it deserves. I welcome all replies.

[cabronjames]

Also, the funds can utilize automatic dividend reinvestments to help get a little more yield out of your stock and bond funds.

for a USian using Vanguard Brokerage as the custodian for my IRA, you can do the auto div reinvest with EITHER the mutual fund OR the ETF. 

I am a VBS customer & do both.  For example, I follow the MediumTex suggest of a synthetic TLT consisting of half EDV (an ETF) & half VUSTX (a mutual fund).  I have both set up to automatically reinvest dividends.

I have yet needed to sell an ETF (in order to rebalance), that has fractional shares due to prior div reinvestments.  I assume all of the fractional share is sold when you sell an ETF.  E.g. whether you have 1.001 shares or 1.999 shares, if you make a sell order for 1 ETF, it will sell out the remainder fractional share amount (whether 0.001 or 0.999).  Perhaps Vanguard maintains an house account for its custodian customers to account for these fractional shares?

[dualstow]

Interesting article in the weekend WSJ this morning: 'Why ETFs Lag Their Indexes'

Since a March 15 low, the three U.S.-sold ETFs that track the broad Japanese stock market all have lost money, even though the indexes they mimic are up. The largest, the $7.2 billion iShares MSCI Japan Index ETF, has lost 0.6%, even though the MSCI Japan index, which the fund tracks, is up 5.3%. Similarly, the $108 million iShares S&P/TOPIX 150 ETF is down 1.32% while its index is up 8.6%, and the $15.2 million SPDR Russell/Nomura PRIME Japan ETF is down 0.78%, while its index is up 6.6%.

A couple paragraphs later, the author explains why.

http://online.wsj.com/article/SB1000142 ... 23990.html

[murphy_p_t]

back on the main topic, from speaking with Vanguard I learned that funds "settle" faster from the sale of the mutual fund (1 day for fund, 3 days for the ETF...as I recall)

[craigr]

The Vanguard ETFs are special as discussed above because they are basically the same fund with publicly traded shares. They actually have a patent pending on this idea. It's a slick setup because it allows Vanguard to do better tax management by trading shares from the fund through the ETF side of things without affecting the open ended fund holders.

Funds are simpler in that you don't have transaction costs involved. If you are making deposits every paycheck for instance you don't have to pay a fee to buy into the fund vs. ETFs most of the time. These costs can really add up.

With ETFs there is a possibility of better long term tax efficiency because they can juggle shares out of the fund also to limit capital gains. Vanguard's approach gives you the best of both worlds.

As for the settling date after a sale, this has never concerned me much because there is not a lot of trading in the Permanent Portfolio. Same thing with intra-day price movements.

In some cases the best asset is going may be an ETF only (like the bond funds that hold Treasuries from iShares). But other times it doesn't matter between ETF vs. fund.