Given the increased popularity of exchange-traded funds (ETFs), you would think that index investors have fallen in love with this investment vehicle. Even though ETFs have only been around since 1993 (whereas the first index mutual fund was introduced in 1975), by the end of 2004 their total net assets amounted to almost half those of index funds (see Table 1). However, a closer look shows that index funds are still the top choice for the majority of retail index investors. Here we will look at the reasons why ETFs have become so popular and analyze whether they make sense - from a cost, size and time-horizon standpoint - as an alternative to index funds.

Table 1 - Comparison of types of funds

Many articles have been written comparing ETFs to index funds, but not much has been written on quantifying the differences to determine when one makes sense over the other.

SEE: Introduction to Exchange-Traded Funds and The Lowdown on Index Funds

In an article entitled "Index Mutual Funds and Exchange Traded Funds, published in the Journal of Portfolio Management in the summer of 2003, Leonard Kostovetsky actually quantifies those differences by looking at the explicit and implicit costs inherent in both ETFs and index funds.

Comparing the Advantages
Because ETFs are flexible investment vehicles, they appeal to a broad segment of the investing public. Passive investors and active traders alike find the features of ETFs attractive.

SEE: Advantages Of Exchange-Traded Funds

Passive institutional investors love ETFs for their flexibility. Many see them as a great alternative to futures. For example, ETFs can be purchased in smaller sizes. They also don't require special documentation, special accounts, rollover costs or margin. Furthermore, some ETFs cover benchmarks where there are no futures contracts.

Active traders, including hedge fund traders, love ETFs for their convenience, because they can be traded as easily as stocks. This means they have margin and trading flexibility that is unmatched by index funds. Ironically, ETFs are exempt from the short sale uptick rule that plagues regular stocks (the short sale uptick rule prevents short sellers from shorting a stock unless the last trade resulted in a price increase).

Passive retail investors, for their part, will love index funds for their simplicity. Investors do not need a brokerage account or deposit with index funds. They can usually be purchased through the investor's bank. This keeps things simple for investors - a consideration that the investment advisory community continues to overlook.

Comparing the Costs
ETFs and index funds each have their own particular advantages and disadvantages when it comes to costs associated with index tracking (the ability to track the performance of their respective index) and trading. The costs involved in tracking an index fall into three main categories. A direct comparison of how these costs are handled by ETFs and by index funds should help you make an informed decision when choosing between the two investment vehicles.

First, the constant rebalancing that occurs with index funds because of daily net redemptions results in explicit costs in the form of commissions and implicit costs in the form of bid-ask spreads on the subsequent underlying fund trades. ETFs have a unique process called creation/redemption in-kind (meaning shares of ETFs can be created and redeemed with a like basket of securities) that avoids these transaction costs.

Second, a look at cash drag - which can be defined for index funds as the cost of holding cash to deal with potential daily net redemptions - favors ETFs once again. ETFs do not incur this degree of cash drag because of their aforementioned creation/redemption in-kind process.

Third, dividend policy is one area where index funds have a clear advantage over ETFs. Index funds will invest their dividends immediately, whereas the trust nature of ETFs requires them to accumulate this cash during the quarter until it is distributed to shareholders at end-of-quarter. If we were to return to a dividend environment like that seen in the 1960s and 70s, this cost would certainly become a bigger issue.

Non-tracking costs can also be divided into three categories: management fees, shareholder transaction costs and taxation. First, management fees are generally lower for ETFs because the fund is not responsible for the fund accounting (the brokerage company will incur these costs for ETF holders). This is not the case with index funds.

Second, shareholder transaction costs are usually zero for index funds, but this is not the case for ETFs. In fact, shareholder transaction costs are the biggest factor in determining whether or not ETFs are right for an investor. With ETFs, shareholder transaction costs can be broken down into commissions and bid-ask spreads. The liquidity of the ETF, which in some cases can be material, will determine the bid-ask spread.

Finally, the taxation of these two investment vehicles favors ETFs. In nearly all cases, the creation/redemption in-kind feature of ETFs eliminates the need to sell securities - with index mutual funds, it is that need to sell securities that triggers tax events. ETFs can also rid themselves of capital gains inherent in the fund by transferring out the securities with the highest unrealized gains as part of the redemption in-kind process.

Table 2 - A comparative look at the costs associated with index funds and ETFs, with 1 indicating the greatest effect on costs and 4 the least.

Which Investment Will You Choose?
Typically, the choice between ETFs and index funds will come down to the most important issues: management fees, shareholder transaction costs, taxation and other qualitative differences. According to the analysis we mentioned earlier by Kostovetsky, a comparison of these costs favors index funds as the choice for most passive retail investors. Kostovetsky's analysis assumes no tracking costs and the more popular indexes.

For example, if you were looking at a holding period of one year, you would be required to hold over $60,000 of an ETF for the management fee and taxation savings to offset the transaction costs. With a longer-term time horizon of 10 years, the break-even point would be lowered to $13,000. However, both these limits are usually out of range for the average retail investor.

The Bottom Line
As with many financial decisions, determining which investment vehicle to commit to comes down to "dollars and cents." Given the comparison of costs, the average passive retail investor will decide to go with index funds. For these investors, keeping it simple can be the best policy. Passive institutional investors and active traders, on the other hand, will likely be swayed by qualitative factors in making their decision. Be sure you know where you stand before you commit.

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