[Disclaimer: These are my own views, not financial advice. Use at your own risk.]
When I first started looking at investing, mutual funds were all the rage. They provided a way to own diverse securities without managing the individual stocks themselves. They also provided professional management of this portfolio. However, they come with fees.
Enter the ETF. An ETF (Exchange-Traded Fund) resembles an individual stock but typically represents a diversified collection of securities. Because they are predominantly passive (they don’t require daily professional, management), they typically offer lower fees than mutual funds (you can tell by looking at the “expense ratio” of your investments). You can also buy and sell them just like a stock whenever the market is open which is a major advantage.
But let’s do some math:
| Fund | Expense Ratio | 15-year Annualized Return | End Value of $10,000 Invested |
|---|---|---|---|
| ITOT (iShares Core S&P Total U.S. Stock Market ETF) | 0.03% | ~12.4% | ~$57,742 |
| SCHB (Schwab U.S. Broad Market ETF) | 0.03% | ~12.43% | ~$57,974 |
| VTI (Vanguard Total Stock Market ETF) | 0.03% | ~12.7% | ~$60,098 |
| FSKAX (Fidelity Total Market Index Fund) | 0.015% | ~12.9% | ~$61,718 |
| VTSAX (Vanguard Total Stock Market Index Fund) | 0.04% | ~12.7% | ~$60,098 |
I was surprised to learn that broad-market mutual funds compete very well with comparable ETFs. How about your ability to trade like a stock? In all fairness, when you’re playing the long-game (and frequent buying and selling are not a priority), that probably isn’t a major factor either.
Enter: Capital Gains Tax.
Everyone’s tax situation is different, so when we’re comparing investments we mostly focus on pre-tax returns – but not all investments are tax-equal. When you get that 1099-DIV at the end of the year and you owe more taxes than you expected, that’s likely because the mutual fund manager has been trading the underlying securities to balance or reconcile the basket of securities, and any capital gains (less any capital losses) they incurred are passed on to you. ETFs benefit from a unique tax treatment in trading their underlying securities, resulting in fewer capital gains distributions passed on to investors.12
Because of this, over that 15-year period with $10,000 invested you would have paid around ~$3,518 in taxes for SCHB (ETF) and ~$11,219 for FSKAX (Mutual Fund) – assuming a 15% capital gains rate (using a yearly tax cost for each of 0.51% and 1.5% respectively). If you hold these in a taxable account, this represents a significant drag on your return.
| Fund | Tax Cost Ratio | Pre-Tax End Value | Post-Tax End Value | Taxes Paid |
|---|---|---|---|---|
| ITOT (iShares Core S&P Total U.S. Stock Market ETF) | 0.47% | ~$57,742 | ~$54,225 | ~$3,518 |
| SCHB (Schwab U.S. Broad Market ETF) | 0.51% | ~$57,974 | ~$54,152 | ~$3,822 |
| VTI (Vanguard Total Stock Market ETF) | 0.49% | ~$60,098 | ~$56,295 | ~$3,802 |
| FSKAX (Fidelity Total Market Index Fund) | 1.5% | ~$61,718 | ~$50,498 | ~$11,219 |
| VTSAX (Vanguard Total Stock Market Index Fund) | 0.46% | ~$60,098 | ~$56,522 | ~$3,576 |
The anomaly here is VTSAX – I believe they use the underlying VTI ETF and tax-loss harvesting (more on that in another installment) to get such a good tax cost ratio.
This supports the efficiency of ETFs, particularly in broad-market, passive strategies in taxable accounts. Of course, not all ETFs or Mutual Funds are created equal (as you see with VTSAX) – always read the fine print.
Good luck!
-Gary
- ETFs and Mutual Funds are not the same: https://www.investor.gov/introduction-investing/general-resources/news-alerts/alerts-bulletins/investor-bulletins-24 ↩︎
- 25 Top Picks for Tax-Efficient ETFs and Mutual Funds: https://www.morningstar.com/funds/25-top-picks-tax-efficient-etfs-mutual-funds ↩︎
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