Should I Invest with ETFs or Mutual Funds?

by Kevin on April 17, 2013

Should you invest with index mutual funds or index exchanged traded funds?

This question has plagued me for quite some time.

When I first opened Roth IRAs for my wife and I the main concern I had was to build up the habit of investing for our retirement rather than really focusing on costs. When you have $5,000 sitting in an account there is no sense squabbling over this mutual fund at 0.5% expense ratio versus that one at 0.25%. The difference is $12.50 for an entire year.

Granted, I wanted to have quality, low cost investments like Vanguard’s mutual funds since they are some of the lowest cost in the industry.

I just didn’t want to split hairs over which one. The difference in cost at that level is negligible.

Now as our portfolio grows I am revisiting the issue of what investments to stick our money into. Should we switch to ETFs?

Comparing ETFs and Mutual Funds

Our portfolio is primarily made up of investments in Vanguard’s Target Retirement 2050 (VFIFX). I picked this investment for the following reasons:

  • It was easy. I didn’t have to sift through thousands of potential mutual fund options.
  • It gave instant diversification. With one investment I would be invested in Vanguard’s Total Stock Market, Total International Stock Market, and Total Bond Market mutual funds.
  • It automatically changed allocations as we age. The fund automatically shifts from the stock investments toward the bond investment as you get older.
  • It was inexpensive. The expense ratio was just 0.18%. That means for every $10,000 invested I would be charged just $18 per year in investment management fees.

For a couple just starting out saving for retirement, it was a no brainer. I could set my automatic investments, know I was diversified, and go back to earning more income rather than fretting over finding a different investment at 0.16% expenses that would save me all of $2 per year.

Since then index focused ETFs have dropped to rock bottom expense costs. When I first started investing they were maybe at 0.10%. Now you can get Vanguard’s Total Stock Market ETF (VTI) for 0.05% expenses. That’s a difference of $13 per $10,000 over the Target Retirement Fund I had picked. (Or $130 per $100,000 or $1,300 per $1 million.)

Should we switch?

What are True ETF Costs?

With ETFs you not only have the expense ratios to worry about, but also your trade costs. ETFs are traded like stocks while mutual funds just accept your money and invest on your behalf without separate trading fees.

If I wanted to recreate our portfolio, this is what it would look like. Let’s assume we have $50,000 in assets:

  • Current Portfolio with Vanguard Target Retirement 2050 (with 0.18% total expense cost)
    • 63.2% Vanguard Total Stock Market Index
    • 26.8% Vanguard Total International Stock Index
    • 10.0% Vanguard Total Bond Market II Index
  • With ETFs:
    • 63.2% Vanguard Total Stock Market ETF (0.05% expenses)
    • 26.8% Vanguard Total International Stock ETF (0.16% expenses)
    • 10.0% Vanguard Total Bond Market ETF (0.10%)

With that mix of ETFs my total expense cost would drop from 0.18% to 0.0845%.

That might not sound like much but over the following dollar amounts you will see it starts to add up.

A savings of 0.0955% in annual expense ratios would equal:

  • $47.76 per year with a $50,000 portfolio
  • $95.52 per year with a $100,000 portfolio
  • $477.60 per year with a $500,000 portfolio
  • $955.20 per year with a $1 million portfolio

It can be a significant chunk of money. And remember, this is annual savings.

But there is one more cost you have to consider before fully making the switch to ETFs: the trade cost to buy and sell the shares. I’ll talk about that in my next post.

{ 1 comment }

@ThatGuyJM April 18, 2013 at 12:57 am

This is a huge coincidence I am in the same situation. I am thinking the exact same thing last week and I actually have a Vanguard target account mutual fund. I also want to switch to the ETF “version” to take advantage of the lower cost. I also considered that it’s cheaper but the trades are the additional cost to consider. One aspect to this plan is that mutual funds, specifically the way Vanguard has it set up is, it is automatically managed. They pull money from the checking and purchase the mutual fund(s), in my situation it’s monthly. If I wanted to continue the frequency of investment, I would get hit with a trade fee on a monthly basis. This can be avoided by making the yearly maximum investment one time (in 21013 – $5,500), unfortunately dollar cost averaging will not be possible. Someone correct me if I’m wrong with my conclusion.

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