WTF Is An ETF?

*Special thanks to reader MF, who graciously corrected an error on my part in the original post. The article has been updated and the error corrected as of 10/15/19.

A consistent question I get from new investors is whether exchange-traded funds (ETFs) or mutual funds are the optimal vehicles for investments in taxable brokerage accounts. This post is an attempt to consolidate confusing information for improved clarity.

It's important to understand that capital gains only occur in taxable accounts. Any advantage of ETFs is entirely irrelevant to assets in tax-deferred (i.e., 401k) or tax-free (i.e., Roth) investments.

What I'm Talking About When I Talk About ETFs

Let's be clear that the type of investing I believe to be easiest to execute and most likely to succeed over time is passively managed, low cost, buy and hold index fund investing. So when I compare and contrast ETFs and mutual funds, I am assuming we are discussing otherwise similar instruments that track comparable index funds.

I am not a fan of actively managed funds generally, whether mutual or exchange-traded (even though some smart people I look up to selectively incorporate such funds into their portfolios).

Why Are ETFs Considered More Tax-Efficient In Taxable Brokerage Accounts?

When you sell an ETF or mutual fund for a price higher than your basis (what you paid to purchase it) you incur capital gains and pay taxes on those gains.

ETFs are designed in a way that allows them to offset capital gains with capital losses. It's complicated, but here is the argument that makes the most sense from reading a variety of explanations.

In a mutual fund, you own a slice of the mutual fund company, but the company (not you) owns the stocks in the index it tracks. When you want to sell, you sell your shares in the company, you don't sell the underlying stocks.

The problem is when many investors decide to sell at once, the mutual fund manager is forced to sell the shares of the underlying stocks to pay you out, causing the mutual fund to pay capital gains on the sale.

In order to meet a large number of possible simultaneous redemptions, some lots of stocks that have appreciated will need to be sold in that moment, incurring capital gains for the fund. The result is that the investors who do not sell their shares incur a portion of the capital gains triggered by those investors who wanted to sell their shares.

This added cost is reflected in higher costs to operate a mutual fund = the expense ratio.

In an ETF, the idea is similar but the legal wrapper is different. You own the ETF company, but because of a tricky legal structure, cashing out of the ETF converts shares in the company into actual shares of the underlying stocks.

Let's go back to the example where many fellow investors want to sell their ETF shares.

Instead of forcing the ETF manager to sell equities and saddling the entirety of ETF investors with the resulting capital gains, those investors are paid "in-kind" with the underlying stocks owned by the ETF.

Here's how that transaction is perceived from a tax perspective:

1. Large institutional investors known as "authorized participants" ask to redeem their shares
2. The ETF manager offloads those lots that have the lowest basis to the authorized participants (they do not get to choose which lots of equities they receive in the cash out), meaning the authorized participants who cash out are faced with paying capital gains.
3. Those who remain invested in the ETF avoids paying capital gains on those stocks that appreciated the most. The ETF is thus able to "flush" capital gains in a manner that mutual funds cannot.

Buy and hold investors of ETFs like you defer paying capital gains during the period when you are holding the ETF compared with those mutual fund owners we described above, who have to partly eat the costs of capital gains incurred when other mutual fund investors redeem their shares. This is the "increased tax efficiency" you hear about.

If this seems like financial sleight of hand, I agree! However, this magic appears to be legal.

ETF Costs

Expense ratios tend to be lower for ETFs than mutual funds, as suggested by the example above.

Commissions to buy ETFs vary, with a selection of commission-free ETFs usually available when your brokerage is the originator of the ETF (Vanguard sells Vanguard ETFs commission-free).

This is changing rapidly with the emergence of commission-free trading brokerages that are disrupting the current model by forcing competitors to similarly eliminate commissions in order to remain competitive.

Differences Between Mutual Funds and ETFs

Unlike mutual funds, there are extremely low minimums to invest in ETFs. You can plop $50 into a Vanguard ETF, whereas you may need $1k or more to invest in a Vanguard mutual fund.

ETFs trade in on the market in real-time, so the pricing is more transparent because the lag between when you order a trade and when that trade occurs is minimal, and the odds of a dramatic price change during that lag are usually negligible.

Contrast this to mutual funds, where you place your order during the day but the fund is not priced until trading is over at the day's end. You and every other buyer will pay the same price for the fund, but it may not reflect the price you thought you'd pay at the time you placed the order.

Most brokerages only permit the purchase of ETFs as whole shares, meaning some of your money will not be invested as it sits in the settlement fund waiting to add up to enough to purchase a whole share.

Those places where you are allowed to purchase fractional ETF shares nearly always involve an expensive broker instead of a low cost discount brokerage which rapidly offsets any benefit of buying partial shares.

You can typically automate investments and withdrawals into mutual funds, but not ETFs, so the former may be preferable for the "set-it-and-forget-it" investor. Note that this is distinct from asking to reinvest dividends.

Why Everybody Loves Vanguard

At Vanguard, index ETFs are designated different share classes of their parent mutual index fund, so there is no great tax advantage to purchasing an ETF over an index fund at Vanguard but this advantage may exist at other brokerages.

If you are a Vanguard purist, the problem is easily solved. All your retirement accounts should hold mutual funds, whereas your brokerage accounts may get a slight benefit from holding ETFs. Commission-free Vanguard ETFs are both the least expensive and most highly regarded options in their class.

Because Vanguard ETFs are structured as different share classes of their parent index fund, there is no tax advantage to purchasing an ETF over an index fund at Vanguard. There were slightly lower expense ratios for some Vanguard ETFs, but these are miniscule (usually a difference of one hundredth of one percent) and many have recently been changed so that the mutual funds and ETFs have equivalent expense ratios.

A little rambly, a lot of information, and a lot of potential for me to get the facts wrong. If I screwed something up and you have a correction to suggest, feel free to email me directly.