Investors who want to build an index-based portfolio have two viable mechanisms: index-based mutual funds and exchange-traded funds (ETFs). By definition, an ETF is a portfolio based on an established index.

The debate between the two typically centers on cost (i.e., expense ratio) and tax efficiency. In this article, we will examine these two variables to see which investment vehicle comes out ahead. Another issue—the ability to buy and sell ETFs during the trading day—is irrelevant for long-term investors and won't be addressed in this study. Data for this study comes from Morningstar Principia as of Dec. 31, 2007; all share classes of index funds were included.

Expense Ratio

The first issue is cost. The expense ratio of a mutual fund or ETF is important to investors because it comes directly out of their pockets. So, which is cheaper, an index mutual fund or an ETF? It depends on the asset-class category.

The asset-weighted expense ratio (ER) was materially different in only two of the seven major asset-class categories: diversified emerging markets and small cap. (Asset weighting assigns proportionally more impact to large funds and ETFs, and less impact to funds and ETFs with smaller asset bases.) The asset-weighted ER of the five diversified emerging-markets index funds was 25 basis points (bps) lower than the asset-weighted ER of the 12 diversified emerging-markets ETFs. In the small-cap blend category, the asset-weighted ER of the 20 ETFs was 9 bps lower than the asset-weighted ER of the 67 small-cap blend index funds. In every other category, the difference in expense ratio was only 5 bps or less (see "Cost Conscious").

The asset-weighted ER is calculated by multiplying each fund's expense ratio by its share of the assets within the category. It is a more accurate representation of the category ER than simply calculating the average ER. The reason is this: Assets are not uniformly distributed among ETFs and index funds. For example, 64% of all assets invested in large U.S. blend ETFs are held by the single largest ETF, which is SPDR Series Trust 1. Similarly, 83% of all large-cap value index fund assets are held by the Vanguard Value Index fund (when summing up the assets in all four share classes).

Due to this asymmetrical distribution of assets, the average ER for asset- class categories must be asset-weighted. For instance, in three of the seven asset-class categories, the largest single index fund had more than 80% of the category total assets. Among ETFs, in four cases the largest single ETF had more than 60% of the category asset total (see "Top Heavy").

Comparing The Big Guys

Recognizing that in many cases the single largest ETF and index fund in a category hold a significant percentage of the assets in that category, we can simplify the comparison between ETFs and index funds by comparing the largest fund against the largest ETF, looking at both ER and tax cost ratio. "Head-to-Head" shows the results.

For example, 63% of all small-cap blend ETF assets were in the iShares R2000 Index, while 53% of all small-cap blend mutual fund assets were in the Vanguard Small-Cap Index. The expense ratios were similar (20 bps for iShares R2000 Index and 16 bps for Vanguard Small-Cap Index). The difference in the tax cost ratio between the two small-cap titans was more significant-0.40 for the iShares ETF and 0.24 for the Vanguard index fund. The Morningstar tax cost ratio measures how much a fund's annualized return is reduced by the taxes investors pay on distributions; the lower the tax cost ratio, the better.

The large-blend category had a total of $153.4 billion in assets across 86 separate ETFs. The SPDR Trust Series 1 (SPY) had assets of $98.1 billion as of Dec. 31, 2007, or 64% of the total assets in that category. On the mutual fund side, Vanguard 500 Index (VFINX, VIFSX and VFIAX) held 26% of the $466.5 billion invested in 240 large-cap blend index funds. While 26% is not a majority of the assets, it is a big percentage, considering how many index funds there are in the large-cap blend category.

The expense ratio of SPY was 9 BPS compared with 14 basis points for Vanguard 500 Index. (Fourteen BPS is the asset-weighted average ER among the three share classes of the index fund.)

On the other hand, the three-year tax cost ratio of Vanguard 500 Index was 0.27 compared with 0.39 for SPY. (Recall, the lower the tax cost ratio, the better.) In the large-cap blend space, the largest mutual fund series was more tax efficient than the largest ETF, but the ETF won the cost battle.

Overall, the largest single mutual fund had better tax efficiency than the largest single ETF in six of the seven asset-class categories. The only exception was large-cap growth. In that case, Power Shares QQQ was only 2 bps lower than Vanguard Growth Index in tax efficiency-a difference too close to determine a clear winner.