How to Choose Between an ETF and a Mutual Fund

So you can get $40 more by buying the mutual fund instead of the ETF -- equal to a $20 commission to buy the ETF and then $20 to sell it later on. But the value of the fund investment is being depleted by $5.54 more per year than with the ETF ($8.48 minus $2.94). So dividing $40 by $5.54 reveals that a rough "breakeven" on buying the ETF is 7.2 years, meaning that in this case the fund makes sense for the first 7.2 years, with the ETF having the overall cost advantage thereafter.

(The above "breakeven" is described as "rough" because those with quantitative inclinations will point out that "linear" rather than "geometric" extrapolations are used. In addition, "quants" who consider the time value of money will note that the "net present value" of the $20 brokerage commission to sell the ETF in the future is really around $16.26, assuming a normalized 3% "discount rate." Moreover, no bid/ask spreads are assumed on the purchase and sale of the ETF. Nor are they factored into the calculations, since that the sale of the ETF doesn't really "cost" $20 in commissions; rather it results in $20 being deducted from the proceeds. In most cases, all of these assumptions would net out to a value not much different than using the simple methodology above.)

In fact, a real-world example of the above "breakeven" analysis exists, as do many others. The no-load Vanguard Large Cap Index Fund (VLACX Quote) and the Vanguard Large Cap ETF(VV Quote), both track the MSCI U.S. Prime Market 750 Index. If we assume 7% portfolio growth, $20 buy and sell commissions on the ETF and a 3-cent bid/ask spread on the initial purchase (note: the growth projection, commissions and bid/ask spreads are all hypothetical and used solely as examples and do not represent forecasts by TheStreet.com Ratings. The annual expenses are based on the midpoints of the projected yearend values.), then the breakeven -- where the ETF becomes the more cost-efficient investment -- comes slightly after the end of the sixth year.

"BREAKEVEN ANALYSIS" OF AN ETF &; OPEN-END FUND Vanguard Large Cap ETF Vanguard Large Cap Index Inv Symbol V V VLACX Objective Tracks perf. of MSCI US Prime Mkt. Index Tracks perf. of MSCI US Prime Mkt. Index TheStreet.com Ratings Grade C+ 0.2% Expense Ratio 0.07% Germany Assumed Ann'l Return * 7% 7% Typical Bid/Ask Spread 3 cents Not Applic. Commissions on Trades 20 No sales/redemption fees Amount ($) Value if Sold ($) Amount ($) Value if Redeemed ($) Advantage of ETF Vs. Fund ($) Initial Expenditure (Includes Brokerage Commission Bid/Ask Spread)** 4,223.00 4,223.00 Brokerage Commission 20.00 0.00 Bid/Ask Split 3.00 0.00 Initial Value 4,200.00 4,223.00 -23.00 Expenses for Year 1 3.04 8.74 Value End of Year 1 4,494.10 4,474.10 4,509.87 4,509.87 -35.77 Expenses for Year 2 3.26 9.34 Value End of Year 2 4,805.43 4,785.43 4,816.22 4,816.22 -30.79 Expenses for Year 3 3.48 9.97 Value End of Year 3 5,138.33 5,118.33 5,143.39 5,143.39 -25.06 Expenses for Year 4 3.72 10.65 Value End of Year 4 5,494.29 5,474.29 5,492.78 5,492.78 -18.49 Expenses for Year 5 3.98 11.37 Value End of Year 5 5,874.91 5,854.91 5,865.90 5,865.90 -10.99 Expenses for Year 6 4.26 12.14 Value End of Year 6 6,281.90 6,261.90 6,264.38 6,264.38 -2.48 Expenses for Year 7 4.55 12.97 Value End of Year 7 6,717.08 6,697.08 6,689.91 6,689.91 7.16 * Value is for illustration purposes only; it does not represent a forecast by TheStreet.com Ratings ** Assumes bid quote is equal to fund's net asset value per share Source: TheStreet.com Ratings .