By Mark Jewell
AP Personal Finance Writer
BOSTON (AP) ? Fund investors who want to put their money to work as cheaply as possible have a couple basic options. They can go with an index mutual fund or a comparable exchange-traded fund.
It's an either-or proposition. There are index funds and ETFs that invest in the same segments of the market. Whether they hold stocks or bonds, the key distinctions are expenses and restrictions on how investors can get in and out.
Now, however, the nation's largest fund company is venturing onto a third path, one that's likely to become well-traveled in coming years.
Vanguard plans to launch 19 new funds later this month that will be first-of-their kind in the industry. Like most broker-sold mutual funds, they will be offered in different share classes, differentiating how an investor pays the sales fee for a fund. But with Vanguard's new funds, the share class will designate whether someone is investing in a mutual fund or an ETF that holds the same underlying investments.
Perhaps more important for individual investors, Vanguard is also launching an ETF version of Vanguard 500 Index, an $87 billion behemoth tracking the Standard & Poor's 500. It's another milestone for a 34-year-old fund that became the first index fund available to individual investors.
The novel mutual fund-ETF hybrid structure grew out of a patent that Vanguard secured before it sought regulators' permission in June to introduce the soon-to-be-launched products.
It creates a new wrinkle in the traditional index fund-vs.-ETF competition. Some investors might choose to keep some cash in an index fund, and another chunk in the same fund's ETF class, rather than one or the other.
"Vanguard is very smart to create an 'and' solution, rather than an 'either/or' solution," said John Osbon, who manages about $45 million at Boston-based Osbon Capital Management, investing clients' money exclusively in ETFs. "You can buy an ETF version and a mutual fund version, whichever flavor works for you."
Mutual funds are priced once a day. This means that when an investor sells, the value is determined by the fund's price at the close of the market. ETFs are priced throughout the trading day and are traded like stocks. That makes it possible to lock in a preferred price without waiting for a closing price, unlike with mutual funds.
Although both are typically cheap, many ETFs now undercut comparable index funds on costs. And ETFs have consistently drawn more cash in recent years than traditional mutual funds ? especially actively managed funds that tend to be costlier than index products. Still, mutual funds hold more than 10 times as much as ETFs.
"I think the trend has legs, and investors are wise to weigh whether an ETF is the better bet for them versus a comparable index fund," says Christine Benz, personal finance director at fund tracker Morningstar.
Because of its latest move, Vanguard could see some investors switch from the established mutual fund share class of its 500 Index (VFINX) in favor of the flagship fund's new ETF share class. Vanguard expects the ETF version will charge an annual expense ratio of 0.06 percent. An expense ratio measures the ongoing charges that investors pay, expressed as a percentage of assets.
For most investors in Vanguard 500 Index, expenses are three times as much: 0.18 percent. That's still inexpensive, but the difference could really add up for an investor sticking with the fund for years. Investors with substantial investments ? $100,000 or more ? pay a discounted 0.07 percent, slightly higher than the new ETF share class.
Most of the other 19 new Vanguard funds are geared toward institutional clients and financial advisers, requiring minimum investments of $5 million.
But there's more than just cost to consider when weighing an ETF or a similar index fund, whether or not they're offered as part of the same fund.
One thing to keep in mind: Although the intra-day trading capability expands an investor's options, ETFs can be held for years without any trading activity. Frequent trading is often ill-advised because it's almost impossible to consistently time your moves correctly. Trading can also trigger brokerage charges, though many ETF providers, including Vanguard, now offer commission-free ETF trades to their own account holders.
The questions to ask:
? Costs. Look beyond expense ratio comparisons and consider any commissions you might pay by switching from an index fund to an ETF. Morningstar's website offers a cost analyzer that can help sort this out.
? Taxes. If you hold an investment in a taxable account ? something other than 401(k)s or IRAs, for example ? you could be hit with paying capital gains taxes on a fund's annual distributions. Whether you're in an index fund or an ETF, chances are the fund's index-investing approach helps shield investors from capital gains. An index fund doesn't buy or sell its holdings as frequently as actively managed funds move in and out of stocks or bonds. So it's less likely to trigger a tax hit for shareholders. However, because of the way ETFs are structured, they tend to have more tools at their disposal than index funds to limit taxes.
? Trading: If you want the daily trading flexibility ETFs offer, they may be a better option.
? How much to put in: If you've got little cash to invest, ETFs don't set a minimum level to get in, above the cost of a single share ? typically, less than $100. Mutual funds require minimum investments of $500 and up, and sometimes as much as $25,000, which could be off-limits for some.
But Benz says costs are still a key comparison to make ? especially now, with investors still trying to recover from market crashes, most recently in 2008:
"We've been through a 10 year period where stocks have returned almost nothing. So investors are wisely paying attention to what they're paying for their investments."
Published: Fri, Sep 10, 2010
