Index Funds Or ETFs? How About Both?

Investors should thank Schwab for pioneering free trades on its in-house ETFs. With the pressure Schwab put on the competitors, now both Fidelity and Vanguard offer free trades on select ETFs. The free ETF trades are a gift to investors.

Free ETF trades make it really easy for small investors to put together a diversified portfolio at extremely low cost because the minimum investment in a ETF is just one share, usually less than $100. See previous post Low-Minimum Index Funds and Commission-Free ETFs for Small Investors.

If you don’t have a problem with meeting the minimum initial investment requirement and you are already investing in traditional open-end mutual funds, should you switch to ETFs?

You probably should, at least for the majority of your portfolio.

Lower cost is the biggest advantage of ETFs over open-end mutual funds. ETFs are primarily index funds. If you are investing in actively managed mutual funds, they usually cost several times more than the comparable ETFs and they don’t necessarily deliver superior results.

If you like index funds for their low cost, you will like ETFs even more since ETFs usually cost less than comparable index funds. Some index funds charge purchase and/or redemption fees; ETFs don’t.

Getting the same investment at lower cost means more money in your pocket. Vanguard offers a cost comparison calculator. I tried it with several ETFs. The ETFs won every time. Here’s an example:

For $30,000 invested in Vanguard Value Index Fund for 20 years at an estimated return of 6% a year, the total cost is $2,865. The total cost of investing in the equivalent ETF is $1,581, or 45% less. Who doesn’t want to save the cost of investing by 45%?

More choices is another reason for choosing ETFs. Vanguard has 29 index funds, but it has 46 ETFs. Schwab has five index funds and 11 ETFs. If you want something not available as an index fund, you may find it as an ETF. More choices means it will be easier to assemble a portfolio exactly the way you want.

ETFs and index funds are not mutually exclusive. Nobody says you can’t have both. Having both not only is OK but maybe even better than having only funds or only ETFs.

If you are not familiar with ETFs, you may be concerned about their trading aspects: the premium/discount to NAV, the bid/ask spread, market orders versus limited orders, etc. etc. If you are a Vanguard customer, don’t be afraid. You don’t have to master trading when you are investing in Vanguard index funds and ETFs. That’s another unique advantage to being a Vanguard customer.

Vanguard index funds offer a unique feature that lets you convert mutual fund shares into ETF shares at the net asset value. Not all Vanguard index funds have an ETF equivalent and not all funds offer conversion, but the majority do (20 out 29 index funds allow conversion to ETF, see list). You can convert the bulk of your index fund holdings to ETFs and still leave a minimum amount in the index funds for periodic purchases and rebalancing. When you accumulate enough index fund shares that make it worthwhile, you can convert them to ETF again.

Because converting from fund shares to ETF shares is done at the net asset value, you can be oblivious to the premium/discount, the bid/ask spread, or market order or limited order. If you have index funds in a taxable account, you don’t have to worry about triggering taxes either, because the conversion is a non-taxable event.

Isn’t it nice to have the best of both worlds? Mutual funds are easier to buy; ETFs are cheaper to hold. Have your cake and eat it too. If you are used to buying index funds every month on a set schedule, you don’t have to change your routine at all. Just convert the bulk of your existing holdings to ETFs and convert again maybe once a year after you do your rebalancing.

Is it too much trouble? I take it that most people have a checking account and a savings account or CDs. The idea is that you use your checking account for day-to-day spending and you use your savings account or CDs for more stable savings. You do that because the savings account or CDs pay more interest. Having both index funds and ETFs is along the same line: index funds for dollar cost averaging and ETFs for long term holdings. I think it’s not too much trouble and totally worth it.

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  1. tarnation says

    If one plans on tax loss harvesting, then one downside to converting MF shares to ETF shares is that one cannot sell only whole tax lots. Since the conversion will generally produce fractional shares in each lot, when one sells there are either fractional remaining shares in a tax lot, or fractional shares come out of a different lot. Obviously, this is merely a nuisance, but one I didn’t think about until after converting. 🙂

  2. RIPathfinder123 says

    If you convert from a vanguard fund to the corresponding vanguard etf, i understand it’s not a taxable event. But what if you later sell said etf at a profit of say, $5,000. How do you determine your basis – is it your average mutual fund basis? Or the basis at which you convert?

  3. theo says

    RIP123, My understanding is that you use the cost basis of your MF at the time of the conversion to calculate any future ETF gains / losses. This info is easily accessible on BEFORE the conversion…

    There are however other unclear technical issues:

    1) what is the short term vs. long term gain(loss) if the new ETF is sold in less than a year from the conversion. Is the conversion time considered the date of the ETF purchase or are the prior MF purchases taken into consideration somehow?

    2) what happens if you sell only a portion of the new ETFs…how would you split cost basis between those and for the remaining ETFs?

  4. Jeremy says

    I did this today in a Roth IRA account. For informational purposes, VBMFX (the total bond market index) is NOT convertible to BND. According to the VG rep, only the institutional share class is directly convertible. In order to convert I must first convert VBMFX to a money market sweep account and then purchase BND tomorrow. Obviously in a taxable account this is a taxable event. So it is important to make sure that your current holding is in fact directly convertible to a VG ETF.

  5. anonymous says

    At Fidelity, their index funds are still a better option than going the ETF way by purchasing the free tradeable iShares ETFs. Fidelity index funds are way cheaper (even though they are very few available). Also, as Bogle has pointed out before, most investors are better of in mutual funds (where there are restrictions on trading). Without the restrictions, the individual investor has repeatedly shown the ability to sell at absolutely the wrong time. Of course, no one can prevent you from shooting your own foot, but here the restrictions have shown to help more than hurt.

  6. Pablo Escobar Mendez says

    I am wondering(out loud what’s going to happen to the Admiral share classes of various Vanguard funds, since the comparable ETFs offer similar/the same ER’s without 50-250K minimums. Do you think it’s curtains for Admiral Class shares?

  7. Harry Sit says

    Pablo – ETFs are basically “poor man’s Admiral shares.” If you don’t have the minimum for Admiral shares, you hide in ETFs. If you have enough money for Admiral shares, some probably prefer to consolidate into Admiral shares instead of doing this Investor shares + ETFs combo. There will be cannibalization of Admiral shares. I see some funds have ETF shares but don’t have Admiral shares. Existing Admiral shares probably won’t go away but there will be less urgency to introduce Admiral shares on new funds.

  8. akb says

    “converting from fund shares to ETF shares is done at the net asset value”

    Sounds like an arbitrage opportunity if the ETF trades at a premium to NAV.

  9. tarnation says

    ““converting from fund shares to ETF shares is done at the net asset value”

    Sounds like an arbitrage opportunity if the ETF trades at a premium to NAV.”

    That is why Vanguard stopped offering conversions on BND, etc.

  10. Doctor Stock says

    I think most “semi-educated” investors could do well to create their own ETFs… and save the fees. With a little know how and advice, investors could do well!

  11. Ted Valentine says

    Thanks for this post tfb. I have been considereing switching to ETFs in my IRAs and am going to implement this plan. I was considering holding out for admiral shares where available, but figure I can convert back there if and when that happens.

    Question: I hold a chunk in total international (VGTSX) that I can move to ETF, I can’t direct-convert these. I assume I’ll have to sell into a money market and then do a purchase on the FTSE World Ex US ETF? How should I play this to not get hammered on the bid/ask spread, etc?

    PS – Love those spreadsheets. Idea: add the ER of the ETF and Fund versions?

  12. Harry Sit says

    Ted – The Vanguard FTSE All World Ex-US Fund (VFWIX) allows conversion to ETF. You can do an exchange from VGTSX to VFWIX and then convert to the ETF. VFWIX charges a redemption fee if held less than 2 months but I don’t think conversion to ETF is subject to the redemption fee.

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