Monday, March 13, 2006

ETF Pros

ETF Pros

bullet Some ETFs may have lower expense ratios than similar conventional index mutual funds. If true, this suggests that ongoing management fees would be lower, which favors ETFs. However, note that most ETFs have expense ratios which are not dramatically lower than the lowest cost conventional index mutual funds with similar investment goals.

bullet ETFs may be somewhat more tax efficient than similar conventional index mutual funds. This increased tax-efficiency is in the form of lower capital gains distributions (which effectively means that an ETF's capital gains tend to be more deferred than a similar mutual fund's would be). The idea that ETFs should have lower capital gains distributions comes from their ability to shed their lowest-basis shares to institutional arbitrageurs through in-kind redemptions. Note that this benefit applies to a much lesser extent to Vanguard's VIPER ETFs. Because they exist as a separate share class of conventional mutual funds, any tax benefit a VIPER ETF generates is shared by investors in the fund's non-ETF shares, thus diluting the beneficial effect for VIPER share owners.

bullet ETFs may have somewhat less "cash drag" than similar conventional mutual funds. Conventional mutual funds typically need to maintain a small amount of their portfolio in cash in order to meet ongoing cash redemptions. An ETF has no such need because it never has to deal with the possibility of cash redemptions. This may provide a slight advantage for ETFs over similar index mutual funds.

Note that if the ETF you are considering has a higher expense ratio than any similar conventional no-load index mutual fund AND the prospective ETF investment would not be in a taxable account (e.g., you are in an IRA), then ETFs will almost certainly underperform the alternative and you should abandon the idea of using the ETF in favor of the alternative.

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