3 main reasons I invest in ETFs instead of mutual funds

Building portfolios using ETFs instead of mutual funds

I first started using ETFs in the early 2000s, when iShares was aggressively launching several new ETFs, and marketing the line of single-country ETFs they had launched back in 1996.ย  ย The Spyder ETF “SPY” has already been around for almost a decade at that point, and sector SPDRs had already been around since 1998, but there’s nothing like two high-budget brands rising to compete with each other (think Apple vs Android a decade later) to make a product category mainstream, whether ETFs vs mutual funds or smart phones vs landlines.ย  At that time, I could already see that ETFs provided better, faster, cheaper, purer access to invest in major global benchmark indexes like the S&P 500, MSCI Japan, or a technology sector index, and thought within a decade, everyone would be using ETFs instead of mutual funds and the latter would become obsolete.

I have stopped buying mutual funds in all the accounts I manage except for HSA and 529 plans, and even in Vanguard accounts, new investments go into zero-commission ETFs rather than mutual funds.ย  Here are the 3 main reasons I prefer to invest in ETFs instead of mutual funds:

#1: ETFs are “open access”, allowing you buy the same shares as the big guys

One of my biggest annoyances about traditional open-ended mutual funds is how they are bought and sold.ย  A mutual fund may be available to be purchased through one brokerage platform and not another, and there are different share classes depending on the amount you invest, and whether the brokerage platform you buy the fund through needs to get paid a commission by the fund company or not.ย  This typically means that an individual investing a few thousand dollars into a fund will be put into a different share class with much higher percentage fees than a larger investor buying a different share class of the same fund.

On the other hand, any investor buying shares of an ETF gets the same share class at the same low cost.ย  An individual or a large pension fund can both buy shares of, for example, the SPDR Portfolio Total Stock Market ETF, and both will pay the same total fund expense ratio of 0.03%/year of assets ($30/year per $100,000 invested).

#2: ETFs often (but not always) have a lower total cost of ownership than mutual funds

It is not true that all ETFs are passive while all mutual funds are active: there are low-cost index mutual funds and relatively expensive active ETFs, but in general and on average, ETFs have a lower annual expense than mutual funds.

As one extreme example, HSBC has a Hong Kong Equity Fund with a portfolio that closely matches the Hang Seng Index, and this mutual fund charges a 4.76% up-front fee plus 1% annual fee, for a total of $5,760 in first-year fees per $100,000 invested.ย  By contrast, the Tracker Fund of Hong Kong, which trades on the Hong Kong stock exchange, provide the same access to the Hang Seng for 0.09% per year ($90 per $100,000 invested).

The above differences are the annual expense ratio within the fund, and do not include the fact that you do need to pay trading costs and exchange fees when you buy or sell an ETF.ย  In an HSBC account, you need to pay the greater of HK$100 or 0.25% per Hong Kong stock trade or US$18 per trade on a US exchange, while low-cost electronic brokerage firms like Interactive Brokers and Saxo have trading costs as low as 0.08% for Hong Kong trades or US$1 for US trades.ย  Even with these trading costs, I often find the total cost of ownership lower for buy and hold investors of ETFs vs mutual funds.ย  Vanguard has even made ETF trading commission-free on their platform.

#3: Flexibility to use limit orders and options

As someone comfortable submitting trades to stock exchanges, I also appreciate the flexibility ETFs provide in being able to submit limit orders (instead of end-of-day market orders), and to buy or write options on ETF positions.ย  This is useful when I have a target price at which I would like to enter or exit a fund position, and I can leave the order to auto-execute when that price is reached.

US tax considerations

One advantage often touted of US ETFs is their relative tax efficiency vs mutual funds, due to their relative passive index tracking and in-kind creation/redemption mechanism within the fund, which pass minimal taxable events on to shareholders.ย  I don’t find tax to be quite as big an advantage for ETFs as I often hold them in IRA accounts or accounts for non-US persons.ย  For taxable accounts, I prefer to hold individual stock positions where I can do tax-loss harvesting, which offers even more tax flexibility than holding a similar basket of stocks within an ETF.

I look forward to reading your questions and comments about ETFs vs mutual funds: