Portfolio Dilemma: ETF or index fund?

An ii Community member asks: I am deciding between an exchange-traded fund (ETF) or the mutual version of a tracker. At the moment, I have chosen mostly Vanguard mutuals but sometimes feel I am missing out.

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Passive funds have become the only way for many investors, thanks to their hard-to-beat returns, low fees and (seemingly) simple proposition. But a question that often crops up is what format of passive fund to back.

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They tend to fall into two types. There’s the exchange-traded fund (ETF), which as its name suggests has its own shares traded on a market such as the London Stock Exchange. And then there’s the so-called mutual fund (or index fund), in which you can buy units. These are available on investment platforms but are not part of a stock market.

You can often find the exact same fund in both formats. 

To give one example, Vanguard’s LifeStrategy franchise launched in the “mutual” format around 15 years ago, and has enjoyed huge success since. That very success led the franchise to also launch in ETF format in 2020.

If we stick with that same example, the Vanguard LifeStrategy 80% Equity A Acc (B4PQW15) fund and the ETF equivalent give you an identical return since the inception of the latter in December 2020, having each returned just shy of 67%.

They will also tend to have the same asset allocations, if sometimes via a different combination of funds, and the same underlying investments. But a few differences need weighing up when you make your choice between the two.

Fees and frequency

One important thing to consider, as ever with passive funds, is fees. Competition remains fierce here and providers can end up cutting their fees, especially in the ETF space. We recently saw Vanguard do exactly that on its FTSE All-World ETF.

We shouldn’t always assume the ETF is cheaper: note that LifeStrategy 80% Equity comes slightly cheaper in its mutual fund form, on a 0.2% yearly fee, versus 0.25% for the ETF. 

With either kind of fund, investors should try and look at any other costs, too, from transaction costs to the effect of trading spreads. These are not always easy to find but will have some impact on your net return.

Funds often try to win out on cost, and our piece on the cheapest trackers covering the main markets gets updated when required to reflect the effect of any major price cuts.

Another big difference between mutual funds and ETFs relates to the frequency with which you can trade, and when pricing data is provided.

To start with the less important detail, valuations on mutual funds are updated once a day whereas pricing on ETFs is constantly changing while the market they trade on is active.

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A similar dynamic applies to trading. You can trade an ETF whenever you want, provided the market it’s on is active at the time. With a mutual fund, if you buy or sell it could take a few days for that trade to go through.

This has a couple of important implications for investors. If you want to buy something quickly, or exit quickly, then an ETF is a much more nimble option. The more active investor might prefer this approach.

On the other hand, vanilla tracker funds such as an S&P 500 ETF are rarely the best option for a targeted trade. 

And for some investors, the fact that things move too slowly with a mutual fund might prevent them from making any rash investment decisions (such as panic selling if they see the market fall) and enforce more of a buy-and-hold approach.

On a fund research note, it’s worth remembering that ETFs can sometimes have much more in-depth portfolio disclosure than mutual funds. 

They generally provide very up-to-date information on things like regional and sector exposure, with many ETFs providing full portfolio holding lists. 

Mutual funds provide monthly updates. Those assessing a fund, or the market tracked by a fund, might therefore use the ETF as a good source of information.

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With both fund structures, investors should always be careful about the options they choose from. 

The accumulation share class of both a mutual fund and an ETF will reinvest dividends, which works well for long-term investors looking to compound returns. 

The distribution or income share class will pay any dividends straight to you.