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Page 4 of 6
ETFs vs. Mutual Funds: An Investment Comparison
There are both qualitative (i.e., investment availability) and quantitative (i.e., cost) issues that need to be addressed when determining whether to include ETFs in 401(k)s. While the primary interest in ETFs is cost-related, there are a number of popular index methodologies that are difficult (if not impossible) to obtain at a similar cost (or at all) using traditional mutual funds. As an example, if a plan sponsor wanted to use the Russell index methodology in a 401(k), it would be impossible to select mutual funds for each of the nine domestic style boxes with mutual funds. However, a number of ETFs currently exist that follow the Russell methodology (see Appendix I).
As another example, it would also be difficult to utilize the Standard & Poor’s indexing methodology through mutual funds as well. While there are a large number of S&P 500 (i.e., domestic large-blend) mutual funds, there are only a few mutual funds that cover the other blend categories, and few, if any, for the remaining value and growth styles (see Appendix I). While each index methodology has its unique advantages, the primary concern of most index investors is gaining a specific market exposure for the lowest total cost. The author likens the different index methodologies to different ways to cut a pie, where in the aggregate, each methodology does a more than adequate job of representing the return of that market exposure. While there have been noted differences in the performance of indexes [Israelsen 2006], there is no discernable optimal indexed methodology. Therefore, when selecting an ETF (or mutual fund) index tracking investment, the key selection criteria is through which methodology the market exposure can be obtained at the lowest cost, or for the lowest expense ratio.
As shown in Appendix I, the Vanguard ETFs (which are based on MSCI’s index methodology) are less expensive for each of the nine style boxes compared with the respective iShares ETFs (both Russell and S&P methodologies). Therefore, a 401(k) plan sponsor looking to select an ETF in order to obtain market exposure to each of these nine domestic asset categories would likely select the Vanguard ETFs, since they are the low-cost option. Fortunately, unlike the Russell and S&P methodologies (both offered through iShares), Vanguard operates mutual funds with the exact same indexing methodology as the ETFs (MSCI), which allows for a relatively easy apples-to-apples comparison between mutual fund and ETF investing strategies. Figures 1, 2 and 3 include a comparison of the Vanguard ETFs for large-cap, mid-cap and small-cap domestic styles to their respective index mutual funds.
As shown in Figures 1, 2 and 3, the relative cost benefit of ETFs depends on the asset size of the investment. The average Investor-share-class Vanguard mutual fund (i.e., no minimum required) costs 14 bps more than its respective ETF, with a median excess cost of 11 bps. [Note: Expense ratios on Vanguard ETFs and mutual funds have been lowered since this analysis was conducted, but the spreads remain similar.] The average excess cost of the Vanguard Signal share-class mutual funds (which are replacing the Admiral-share classes in retirement plans) is only 2 bps compared with its respective ETF, with a median excess cost of 0 bps. The average and median of the Vanguard Institutional-share class mutual funds, though, is actually 2 bps less expensive than its respective ETF.
Based on the differences in expense ratios, the benefits of ETFs clearly depend upon the level of plan assets. A pooled ETF arrangement would make sense for smaller plans that would have to use the Investor-share classes if the total costs of pooling the ETF (both implicit and explicit) are less than 14 bps. For larger plans that could use Signal-share classes, if the total costs of pooling are less than 2 bps, it could make sense. If the plan is very large (assets of $200+ million) and could use the Institutional-share classes, ETFs are never likely to make sense since the Institutional-share classes were less expensive than their respective ETFs.
In the aggregate, since the expense ratio differences between the ETF and mutual fund strategies were so small (at most, 14 bps for Investor-share classes), it is unlikely that any material benefits are going to be obtained from unitizing an ETF, once considering all the costs (both explicit and implicit). In fact, it appears that once all the costs are considered, in order to make ETFs 401(k)-ready, it is highly likely that any type of pooled ETF arrangement would end up costing more than a mutual fund approach, which can be had for a lot less effort.
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