Though it's true that many of the same risks plaguing exchange-traded index funds also apply to index mutual funds, Burns says mutual funds might have a tighter tracking error because they only trade once daily. "It's easier to say $5 million came in the door today, so I can buy all 700 of these bonds we need," he says. With an exchange-traded fund, this process is happening continuously.
Different index fund structures also can make a difference. Vanguard Group's emerging market exchange-traded fund, for example, has a tighter tracking error than many other similar ETFs because it has a trading partner in a sibling mutual fund, Burns says. Vanguard can keep a smaller, less costly and more manageable number of holdings in its exchange-traded fund share class, and balance it out by trading securities in lieu of cash from its mutual fund.
So what should a financial advisor consider when choosing mutual funds for clients? "We wanted indexes that were modular," says Peter Crawford, the senior vice president for Schwab Investment Management Service, which uses Dow Jones-indexed exchange-traded funds. "We wanted to make sure if you bought a large-cap and small-cap ETF that there was no unintended overlap."
Schwab also seeks objective rules-based indexes rather than an index whose composition is chosen by committee. A committee, Crawford says, can bring subjectivity into the process. Schwab also aims for broad-based indexes so that the impact of a merger or bankruptcy would be minimal.
Crawford adds, however, that experience and customer service were also big factors to Schwab when it chose its indexes. But not everybody agrees, in these days of proliferating indexes and their hidden pitfalls, that all those factors are necessarily the most important criteria for selecting these products.