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Index Mutual Funds and Exchange-Traded Funds Authors: Leonard Kostovetsky Source: Journal of Portfolio Management Date: Summer 2003 |
The recent surge in popularity of ETFs (exchange-traded funds) has led to growing amounts of research into their advantages and disadvantages. But Kostovetsky notes that little of this research has compared the total costs borne by investors of the two comparable passive investment techniques, namely ETFs and index funds. The only study is that by Dellva (2001), who concludes that, because of brokerage commissions, ETFs are not attractive for small investors. But this study did not quantitatively model the differences in costs between the two. So, in the present article, Kostovetsky provides a quantitative comparison of the explicit and implicit costs incurred by ETFs and those of index mutual funds.
Kostovetsky first explains how index funds and ETFs differ with regards to the three sources of costs: management fees, shareholder transaction costs, and taxation costs. He notes that differences in the costs of ETFs and index funds are small, but that they are worth analysing, as cost is an essential argument in selecting passive managed funds. For example, management fees are usually less than 0.5% per year for index funds, but ETFs have been able to offer expense ratios even lower than those of the cheapest of index funds. Investors must, of course, pay commissions to the brokerage house and fees to the market makers for ETFs, which must be purchased on the secondary market. Most index funds, by contrast, do not charge commissions on transactions. Finally, ETFs are more tax efficient.
Kostovetsky constructs one-period and multi-period models to examine a choice of ETFs or index mutual funds, given the management fees, transaction costs and tax efficiency cost variables. The models include nine independent variables describing all the costs. These models allow him to construct the final investment value of both index funds and ETFs, including all their respective costs, and to evaluate the relative advantages and disadvantages of these two products. Some parameters, such as the initial amount invested, capital gains, distribution ratios, expense ratios, or capital gain tax rates, can be adjusted in the model to evaluate their influence on the results. The use of the multi-period model makes it possible to examine the results for different time horizons.
The result of this study is that small investors should, under most of the conditions analysed, prefer index mutual funds to ETFs. This finding is explained by high trading costs for ETFs. However, the longer the holding period, the more economical ETFs become relative to index mutual funds. All the same, the effect of the time horizon is quadratic, not linear. In addition, for large investments, ETFs are superior to index funds. In that case, the effect observed is linear with respect to the amount invested and the author identifies a threshold over which ETFs outclass mutual funds.
Kostovetsky adds some qualitative considerations to his quantitative analysis. He notes that ETFs have a qualitative advantage over index funds, as they can be sold at any time of the day, while index funds can be negotiated only at the end of the day. In addition, ETFs can be sold short and can serve in hedging strategies. Index funds, however, are more accessible, especially to the average investor. The author suggests extending his analysis by, for example, looking into the impact of changes in tax rates on investor preferences for index funds or ETFs.
References
Dellva, W., “Exchange-Traded Funds Not for Everyone”, Journal of Financial Planning, April 2001, pp. 110-124.
