vestors, restricting the frequency of trades and reducing leverage is ben-
eficial to their total returns.
On the cost side, all these vehicles are very efficient. Index mutual
funds are available at an annual cost of 20 basis points or less a year, and
most ETFs are even cheaper. But both ETFs and futures must be bought
through a brokerage account, and this involves paying both a commission
and a “bid-ask spread,” although these are quite low for actively traded in-
dexes. On the other hand, most index funds are no-load funds, meaning there
is no commission when the fund is bought or sold. Furthermore, although
index futures involve no annual costs, these contracts must be rolled over
into new contracts at least once a year, entailing additional commissions.
It is on the tax side that ETFs really shine. Because of the structure
of ETFs, these funds generate very few if any capital gains. Index mutual
funds are also very tax efficient, but they do throw off capital gains. This
means funds must sell individual shares from their portfolio if investors
redeem their shares or if stocks are removed from the index. Although
capital gains have been small for most index funds, they are larger than
ETFs.^10 Futures are not tax efficient since any gains or losses must be re-
alized at the end of the year whether the contracts are sold or not.
Of course, these tax differences between ETFs and index mutual
funds do not matter if an investor holds these funds in a tax-sheltered
account, such as an individual retirement account (IRA) or a Keogh plan
(futures are not allowed in these accounts). However, if these funds are
held in taxable accounts, the after-tax return on ETFs is apt to be higher
than it would be for even the most efficient index fund.CHAPTER 15 The Rise of Exchange-Traded Funds, Stock Index Futures, and Options 263
TABLE 15–1
Comparison of Indexed InvestmentsETFs Index Futures Index Mutual Funds
Continuous Trading Yes Yes No
Can Be Sold Short Yes Yes No
Leverage Can Borrow 50% Can Borrow over 90% None
Expense Ratio Extremely Low None Very Low
Trading Costs Stock Commission Futures Commission None
Dividend Reinvestment Yes* No† Yes
Tax Efficiency Extremely Good Poor Very Good
*Depends on policy of brokerage firm
†Dividends built into price(^10) From 1997 through 2006, there was no capital gain distribution from spiders (S&P 500 ETFs),
while the Vanguard 500 Index Fund has had several (although none since 2000).