Vanguard Mutual Funds vs. ETFs: Which Are Better?

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Vanguard LogoWhen Vanguard lowered its stock and ETF trading fees this week, I received an email from Eric, one of the long time readers of Bargaineering. He wondered if this made Vanguard ETFs superior to their mutual funds, to which I was pretty sure the answer was “Yes.”

You have to make the assumption that the mutual fund and the ETF will track the underlying index in the same way. If they’re run by the same company, in this case Vanguard, I think this is a fairly safe assumption to make. If there is no tracking error, then it comes down to costs. Whichever investment is cheaper, wins.

Mutual Funds vs. ETFs

Here’s a quick recap on the practical differences between mutual funds and ETFs: Exchange traded funds (ETF) are mutual funds you can buy and sell throughout the day. There are underlying structural differences in how they’re created, but for our purposes that’s the only practical difference.

The Trade-Off

The trade-off was that mutual funds tended to have larger minimum investment requirements but you could get into them for free (a mutual fund company doesn’t charge you money to buy and sell shares of the fund). You’ll pay a transaction fee when you buy and sell shares of an ETF, like any other stock.

If your plan is to accumulate shares and dollar cost averaging, mutual funds make more sense because of the transaction fees. Once you reach the initial minimum, additional investments limits are much lower. For Vanguard’s 500 Index, the minimum initial investment is $3,000 but additional investments are only $100. For the Fidelity Spartan 500 Index, the minimum initial investment is $10,000 but there is no minimum additional investment amount.

Are ETFs Better?

It comes down to costs. Now that Vanguard gives free ETF trades, you need to compare their expense ratios. The Vanguard Total Stock Market ETF (VTI) has a mutual fund version, VTSMX (Investor Shares) and VTSAX (Admiral Shares). It turns out that the expense ratio of the ETF is the same as the Admiral Shares, which normally requires you to have a $100,000+ balance in that fund. The Investor Shares fund, VTSMX, has an expense ratio of 0.18%, versus the 0.07% of the ETF and Admiral shares.

VTI-VTSMX-VTSAX 10 Year Performance

Based on Vanguard’s own charts, it appears the ETF is better. The ETF is the blue line, whereas the mutual funds, in yellow and red, are below it in the return chart. The chart may be inaccurate as we’d expect there should greater divergence at the end, reflecting the Investor class shares’ higher expense ratio. Whatever the case may be, the ETF doesn’t perform any differently than the mutual fund and now it’s cheaper.

It appears that, with these fee changes, Vanguard ETFs are superior to Vanguard Mutual Funds of the same type.

Do you agree?

{ 33 comments, please add your thoughts now! }

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33 Responses to “Vanguard Mutual Funds vs. ETFs: Which Are Better?”

  1. Glenn Lasher says:

    Please expand, or at least define your acronyms at first usage. I read ETF as Early Termination Fee because, as of the moment of this writing, I still don’t know what it means, and scanning the article quickly provided no clue to what it is about and therefore to whether or not I want to read it.

    …so I didn’t.

  2. Jamie says:

    One consideration is that mutual funds are more regulated that ETFs (a large reason for the difference in both costs and performance). Regulation is often associated with less risk (arguable, I know). But still, you should understand all aspects of an investmemnt, not just costs and performance.

  3. cubiclegeoff says:

    I’m not sure how often capital gains are associated with Vanguard Mutual funds in a taxable account, but if there are capital gains (and associated taxes), this would make the ETFs more appealing since you wouldn’t have capital gains until you sold the ETF shares themselves.

  4. nickel says:

    I’m pretty sure that the numbers on that graph are theoretical, and that you’ll actually lose some ground on the ETF due to the bid/ask spread when trading. Also, you can’t do auto-investment with ETFs (unless perhaps your broker offers a special mechanism for that).

    • Jim says:

      Yeah, I think they may be theoretical, but why the difference then?

      • nickel says:

        They outperform on paper because they have slightly lower fees, but your trading costs in the real world (even with free trades, you’re still subject to the bid-ask spread) would eat into that advantage.

      • nickel says:

        To clarify, the graph most likely reflects the intrinsic value of the shares, but when you buy you may slightly overpay and when you sell you may get slightly underpaid relative to the intrinsic value (I know you know what I’m talking about, Jim, but others might not). Interestingly, I think that exchanges from fund shares to ETF shares are done based on intrinsic value, so you avoid the bid/ask issue when converting.

  5. BradPK says:

    ETFs and Mutual Funds are different investment products, probably because they serve a different purposes. As perfectly mentioned in the article, there are few differences among the two. Hence, a person, rather than looking at minor profit margins, would consider the most convenient option before investing. However, you have pointed out an interesting thing, which would benefit many.

    • poscogrubb says:

      I’m still confused about what ETFs actually are and how they work. The original post says we have to assume that ETFs and index funds track the market the same (do they have different mechanisms for tracking?). One commenter says they are less regulated than mutual funds. Another commenter says it has something to do with active trading – so its price is more volatile…? You say that ETFs and mutual funds serve different purposes (what purposes?).

      And yet, their only practical difference is cost structure? I don’t get it!

  6. zapeta says:

    Given that the fees are lower, the ETFs make sense. My balance is lower than 50k so I’d be subject to the $20 a year service fee so that figures in to the equation. In the example above, the difference in the expense ratios is .11%. If your invested assets were under about 19k, the additional $20 fee would make your expenses higher using ETFs (feel free to check/correct my math). If your assets are higher, then the ETFs make sense. If you have over 50k and assets the service fee is waived and then ETFs definitely make sense.

    • Jonathan Wright says:

      Vangurad will waive the $20 fee with e-delivery of statements. Any easy way to avaoid the $20 loss.

      • Texas Wahoo says:

        That waiver only applies to Vanguard Mutual Funds, not Vanguard Brokerage Accounts. You have to have 50k to get out of the $20 charge for the brokerage account.

  7. DIY Investor says:

    Given that the fees are lower I believe the ETFs are superior. Although I don’t condone active trading it is comforting to me to be able to sell or buy during the day at a known price. In volatile markets like we have today for example, it is real easy to reduce or add cash with ETFs.

  8. I second what nickel said. The bid/ask spread could hurt you on ETFs (it could also help you). It’s an unknown variable because you don’t know what it will be in the future when you buy again or sell. However, the longer you hold and the fewer transactions you make, the less this factor matters.

    Also, as zapeta pointed out, the $20 service fee for accounts under $50,000 will wipe out most if not all of your savings on the expense ratios. You’d need to have at least $18,182 for it to make sense then.

    • I forgot to mention NAV premiums/discounts as another unknown variable. Again, it’s not a big deal if you hold the ETF for a long time and make few transactions.

      The other concerns I have are more psychological. Could using ETFs push people toward market timing and obsessing over every fluctuation in the prices? Possibly, and that could be quite detrimental.

  9. Chris says:

    I think one factor that’s not taken into consideration is the ability to automate contributions. You can automate investments into mutual funds because they have one set value per day, the net asset value. ETFs fluctuate like stocks every minute or more, so you can’t automatically invest in those because investors would argue on their settle price.

    If you want to “set it and forget it,” you’ll probably need to stick with mutual funds.

  10. Jonathan Wright says:

    A quote from Vanguard’s website:
    We charge a $20 annual account service fee for each Vanguard fund with a balance of less than $10,000 in an account. This fee doesn’t apply if you sign up for account access on and choose electronic delivery of statements, confirmations, and Vanguard fund reports and prospectuses.

  11. Jonathan Wright says:

    ETFs can also only be bought as whole shares. This makes gradual investing of $25 much more difficult.

  12. LC says:

    Jon Wright-

    Depends on your broker…I buy whole dollar amounts of VTI in my brokerage account and the broker allows partial shares to be purchased, so that is incorrect.

    ETF’s should be purchased in large blocks, keeping transaction fees under 1% optimally. If your broker charges $10 to purchase, you really should be gathering up, at least, $1000.00 before you buy.

    For example, don’t dollar cost average into an ETF for $100/month when your broker charges $7.95 per transaction.

    If VTSMX (Vanguard Total Stock Market Index) is part of your overall asset allocation with intentions to hold long term, as you continue to build up to say $25,000 (or maybe even smaller at $5,000 or $10,000), I think it makes perfect sense to “sell” to get into VTI (Vanguard Total Stock Market Index) and go from .18% to .07%. Leave enough in the VTSMX account to remain open and continue to add new monies into the VTSMX until you get to another large sum and continue the process….

    I always thought ETF stood for extra terrestrial farts…Who knew…

  13. Joe says:

    Vanguard mutual funds no longer need a $100 minimum for recurring deposit. I believe the new minimum amount is $1.

    While ETFs may have better returns on paper, actual investors achieve lower returns. Given their stock-like nature, market timing is more often used and therefore ETF investors buy high and sell low. Due to purchase frequency limits, mutual funds are for buy and hold investors.

  14. Carl says:

    Careful looking at that chart and concluding the ETF is better… looks to me like the ETF line doesn’t start until April ’01, a year after the start of the graph, when the other funds start at $10k. By April ’01, the other funds have already lost $1000-$1500 compared to the reference $10k for the ETF, so it is not a fair comparison. A better comparison would be to look at the 5 year chart, where all 3 funds can start at the beginning of the timeline.

  15. eric says:

    Oh I guess I jumped the gun by leaving the comment on the earlier Vanguard post.

    Thanks a lot for breaking it down Jim! Just what I was hoping to read. 🙂

  16. Philip White says:

    Another advantage of ETFs over mutual funds is how they’re taxed.

    Open-ended mutual funds, which is what Vanguard’s funds are, are required to buy and sell the underlying securities to exactly match the number of shares they have outstanding. (I am not sure whether this is daily or not.)

    Selling underlying securities is a taxable event, and these are propagated to mutual fund holders. This is probably the main reason Vanguard actively discourages frequent trading by imposing early redemption fees and two-month purchase restrictions upon a sale.

    ETFs, on the other hand, are traded on secondary markets, so the companies that make them (Vanguard, SPDR, iShares) don’t need to constantly buy and sell underlying securities to match demand. As someone earlier said, this means that you don’t incur any taxes until a sale.

    • Yes, ETFs can be more tax efficient (though the benefit is slight compared to index funds). But how many people actually need to worry about taxes?

      Most people are investing for retirement. Most people don’t max out their tax-advantaged options. Most people don’t need to worry about the tax advantages of ETFs versus mutual funds.

      This isn’t to say you should ignore the advantages. But it’s just not that important for the average investor.

  17. BrianC says:

    One day-trader I used to follow preferred ETFs over mutual funds for his retirement portfolio because he thought it would be easier to go to cash if he needed to do so in a hurry. Of course, given how some brokers went down on Thursday, you may not be able to make any trades when you really need to…

  18. NickS says:

    ETFs not only have lower fees, but they are more liquid assets, which is advantageous if you need to sell. If you are diligent you can easily buy below NAV for a nice little bonus, which you can’t do with mutual funds.

    I’ve invested in vanguard and several other ETFs for the long term in my Roth IRA. I am not a fan of VTI because I feel its too broad, if a certain portion of the market is outperforming its better to invest in that sector via and ETF and quarterly re-asses investment strategies. For example small caps with VB or VBK, emerging markets with VWO, Junk bonds with EMD, JNK, or higher quality bonds with BIV or BND, and a good mix of dividend paying stocks like SDY.

  19. The key factor with regard to etf’s vs. mutual funds is the commission charged to purchase etf’s. Because you are charged a commission for each etf purchase, they are unsuitable for regular investing (monthly or quarterly). For regular investing, mutual funds are more cost effective.
    Thanks for a great blog!

  20. The longer your holding period, the bigger advantage ETFs have, unless you can qualify for Admiral shares. With Vanguard eliminating the commissions, the pertinent factors become the spreads and ETF pricing in relation to Net Asset Value. If I had to rank the Vanguard offerings in preferred order I’d say Admiral shares are most desirable, followed by the ETFs, then the regular shares. For those investing in Emerging Markets or Small Cap International, there’s no question the ETFs are the best deal.

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