Index Battle

Reprinted from Financial Planning Magazine, October 2008
Craig L. Israelsen and April Recksiek

nvestors that want to build an index-based portfolio have two viable routes: use index-based mutual funds or exchange traded funds. By definition, an exchange traded fund (ETF) is a portfolio based on an established index.

The debate between the two typically centers on cost (i.e., expense ratio) and tax-efficiency. A third issue, that being the ability to buy and sell ETFs during the trading day is essentially irrelevant for long-term investors and won't be addressed in this study. Data for this study were obtained from Morningstar Principia as of December 31, 2007.

First issue: cost. The expense ratio of a mutual fund or ETF should be a big deal to investors inasmuch as it comes directly out of their pocket. So, which is cheaper, and index mutual fund or an ETF? It depends on the asset class category. As shown in "Cost Structure" the asset-weighted expense ratio was materially different in only two of the seven major asset class categories. (Asset-weighting assigns proportionally more impact to large funds and ETFs and less impact to funds and ETFs with smaller asset bases). The asset-weighted expense ratio of the five diversified emerging markets index funds was 25 bps lower than the asset-weighted expense ratio of the 12 diversified emerging market ETFs. (All share classes of index funds were included in this study). In the small cap blend category, the asset-weighted ER of the 20 ETFs was 9 bps lower than the asset-weighted ER of the 67 small cap blend index funds. In every other category, the difference in expense ratio was only 5 bps or less (see "Cost Conscious").

Cost Structure

Cost Conscious

The asset-weighted expense ratio is calculated by multiplying each fund's expense ratio by its share of the assets within the category. It is a more accurate representation of the category expense ratio than simply calculating the average expense ratio. The reason is this: assets are not uniformly distributed among ETFs and index funds. For example, 64% of all assets invested in large US blend ETFs are held by the single largest ETF, which is SPDR Series Trust 1. Similarly, 83% of all large cap value index fund assets are held by the Vanguard Value Index fund (when summing the assets in all four share classes).

As a result of this asymmetrical distribution of assets, the "average" expense ratio for asset class categories must be asset-weighted. For instance, in three of the seven asset class categories, the largest single index fund had more than 80% of the category total assets. Among ETFs, in four cases the largest single ETF had more than 60% of the category asset total (see "Top Heavy").

Top Heavy

Recognizing that in most cases the largest single ETF or index fund holds a huge percentage of the assets within a particular asset class category, we can simplify the comparison between ETFs and index funds by comparing the largest fund against the largest ETF. The results are shown in "Index Grid".

In the Large Blend asset class category, there was a total of $153.4 billion in assets across 86 separate ETFs. The SPDR Trust Series 1 (SPY) had assets of $98.1 as of 12/31/07, or 64% of the total assets in that asset class category. On the mutual fund side, Vanguard 500 Index (the trio of VFINX, VIFSX, and VFIAX) held 26% of the $466.5 billion invested in large cap blend index funds. The 3-year tax cost ratio of Vanguard 500 Index was 0.27 compared to 0.39 for SPY. The lower the tax cost ratio the better. The expense ratio of SPY was 9 bps compared to 14 basis points for Vanguard 500 Index. (14 bps is the asset-weighted average expense ratio among the three share classes of Vanguard 500 Index). In the comparison of the large cap blend titans, the mutual funds edged out the ETF in the area of tax efficiency, but the ETF won the cost battle.

Overall, the largest single mutual fund had better tax efficiency than the largest single ETF in 6 of the 7 asset class categories. The only exception was large cap growth. In that case, the difference in tax efficiency between Power Shares QQQ was only 2 bps lower than Vanguard Growth Index-a difference too close to determine a clear winner.

In the area of cost (or annual expense ratio), the largest single mutual fund had a lower expense ratio than the largest single ETF in 6 of the 7 asset class categories. However, in several cases the difference was small (2 bps difference in foreign large blend, 4 bps in large growth, 5 bps in large value, 4 bps in small blend).

Exchange traded funds represent a low cost, tax efficient method of investing in the underlying index. The largest index-based mutual funds offer the same benefits: low cost, tax efficient exposure to the underlying index. When comparing the largest index fund against the largest ETF in a given asset class (which often represents the lion's share of the assets in that respective asset class) the index-based mutual fund tends to have lower cost and better tax efficiency.

The debate regarding the merits of ETFs vs. index-based mutual funds will undoubtedly continue. But, based on these findings, either product-if wisely chosen-offers real value to investors seeking to mimic the performance of the index of their choice. If forced to hand out a first place ribbon…it would go to the largest index-based mutual funds…or in other words I would mail the ribbon to Valley Forge.

Index Grid

*Includes all share classes of the largest mutual fund.
**Asset-weighted average for all share classes of the largest mutual fund. A lower tax cost ratio is better.

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Craig L. Israelsen, Ph.D. teaches family finance at Brigham Young University. He is a principal at Target Date Analytics LLC (www.TDBench.com) and author of "7Twelve", a guide to building diversified, multi-asset portfolios. To purchase a copy of 7Twelve, send an email to Jim Eccleston at jeccleston@snsfe-law.com.


April Recksiek is a student at Brigham Young University.