What advantages do exchange-traded funds have over mutual funds?
Exchange-Traded Funds (ETFs) are growing ever more popular, as they were created to combine the best characteristics of both stocks and mutual funds into a combined investment vehicle.
Four of the common advantages of ETFs over mutual funds include the following:
- Tax-Friendly Investing - unlike mutual funds, ETFs are very tax-efficient. Mutual funds typically have capital gain payouts at year-end, due to redemptions throughout the year; ETFs minimize capital gains by doing like-kind exchanges of stock, thus shielding the fund from any need to sell stocks to meet redemptions. Therefore, it is not treated as a taxable event.
- No Investment Minimums - Several mutual funds have minimum investment requirements of $2,500, $3,000 or even $5,000. ETFs, on the other hand, can be purchased for as little as one share.
- Lower Cost Alternative - The average mutual fund still has an internal cost well over 1%, whereas most ETF funds will have an internal expense ratio typically between 0.30-0.95%. Plus, ETFs do not charge 12b-1 fees (advertising fees) or sales charges, as do many mutual funds.
- More Trading Control - Mutual funds are traded once per day at the closing NAV price. ETFs trade on an exchange all throughout the trading day, just like a stock. This allows you greater purchasing/selling price control and the ability to set protection features, such as stop-loss limits on your investments.
For additional reading, check out Mutual Fund Or ETF: Which Is Right For You?
This question was answered by Steven Merkel
The advantages ETF’s have over Mutual Funds are
1.Investment Strategy and Style Drift
a. ETF’s are mostly passive. This means the investments are added based on a specific index strategy such as the stocks listed in the S&P 500 index. The shares and percentages owned of the underlying companies in the ETF equal those listed in the S&P 500 Index. An ETF follows a specific and preordained index therefore the ability for the manager to ‘drift’ from this index is extremely difficult because the only time the manager is buying and selling securities is when the corresponding index removes a company or adds a company.
b. Mutual Funds are typically actively managed. This means the investment are chosen by a professional portfolio manager based on an investment strategy determined by the portfolio manager. The portfolio manager will buy and sell stocks depending on whether she believes they will outperform other shares. This discretion allows the possibility for the manager to stray from the original stated investment objective over time. If done correctly an investor can benefit from this discretion. If done incorrectly it can hurt an investor.
a. ETF’s follow a specific index of securities, especially the larger ETF’s such as the S&P 500, that are known therefore the securities owned in the ETF are known on a daily basis as well.
b. Mutual Funds have securities being bought and sold at various times and amounts therefore the securities and percentage of holdings will vary over time. Mutual funds are required to report their holdings quarterly.
a. When an ETF investor sells the shares of their ETF, the manager is transferring the shares to someone else without creating a capital gain.
b. Mutual Funds can create capital gains when an investor sells because the underlying shares need to be sold in order to give money to the seller. Any capital gains are passed on to investors at the end of every year.
a. ETF’s have lower trading expenses since the amount of companies shares being bought and sold are limited to only the instances when the index adds or removes a company. This limits the trading costs. Also, since the investment strategy is usually passive the management fee is lower.
b. Mutual Funds can have higher internal trading fees because the frequency of purchases and sales are usually higher which increases the trading costs. Additionally, the portfolio manager is actively making decisions on which shares to buy and sell therefore the management fee is typically higher.
a. ETF's can be sold during market trading hours
b. Mutual Funds are bought and sold at the close of each trading day.
ETFs are investments traded on stock exchanges that hold assets such as stocks, bonds, and commodities. Traditionally, they been index funds and have similar valuation features to mutual funds and Unit Investment Trusts (UITs). Here are advantages that ETFs have over mutual funds:
- Expenses - The typical expense ratio is from 0.1% to 1% versus 1% to 3% for a mutual fund.
- Tax efficiency - You can sell at your convenience and there are no unexpected capital gains as with a mutual fund.
- Flexibility - Since ETFs are traded on an exchange, you can sell them during trading hours and not at the end of the day as with a mutual fund.
- Control - ETFs do not have fund managers and can be sold at your discretion, the opposite of a mutual fund.
- Efficiency - Without a fund manager that can possibly make rash decisions, there are fewer risks than a mutual fund.
Before making investment decisions, make sure to consider all of the pros and cons.
If you have any further questions, I'd be happy to help.
First, let's discuss what the two have in common. Usually, exchange traded funds (ETFs) and mutual funds are diversified. This means the funds hold the stock and / or bonds of many different companies. So, both represent good ways to achieve a diversified portfolio without having to buy hundreds or thousands of stocks and bonds yourself.
That said, ETFs do have some advantages over mutual funds. The advantages are:
- Lower Expense Ratios- Nowadays, investors can purchase ETFs with expense ratios of less than .1%. Meanwhile, the average mutual fund charges an expense ratio of 1.25%
- No Sales Charges- Some mutual funds have a sales charge, which is an additional charge that is applied when an investor buys or sells a fund. Many A share American Funds, for instance, currently charge a 5.75% sales charge on purchases. ETFs do not usually have such sales charges.
- Lower Transaction Fees- Mutual funds tend to trade more than index funds. Mutual fund companies must pay to trade; therefore, investors will pay transaction costs that are NOT included in the expense ratio. On average, mutual fund trading fees costs a fund investor another 1.44% a year while index fund trading costs are lower. In fact, mutual funds overpay for trades on purpose, in order to receive benefits; this complicated and underhanded practice is known as a "soft dollar arrangement" and you can read about it in this Investopedia article.
- Higher Tax Efficiency- ETFs are more tax efficient than mutual funds. This is because mutual funds pay out larger amounts capital gains to their shareholders every year. For instance, from 2000 to 2010, mutual funds paid out about 7% of their Net Asset Value to shareholders. During the same period, ETFs paid out capital gains of .02% of their Net Asset Value. While this might sound good, the ability of ETFs to retain this money is an advantage over mutual funds. Since ETFs are able to retain their earnings instead of paying them out, this results in less tax liability to owners of the fund. Note: This is only a tax advantage in non-qualified accounts.
For all of these reasons, I typically recommend ETFs over mutual funds. While everything has advantages and disadvantages, when it comes to ETFs, the advantages outweigh the disadvantages.
There are 3 major advantages Exchange Traded Funds (ETFs) have over Mutual Funds:
- Lower fees - Typically, expense ratios for ETFs are lower than similar mutual funds. Also, ETFs don't have sales loads while most mutual funds do.
- Tax efficiency - ETFs have low turnover because they are mostly index funds, this reduces capital gains exposure. Additionally, when you sell an ETF there is usually a buyer on the other end, this means the fund company doesn't have to sell the underlying stocks to pay the investor their money. Mutual funds must sell the underlying security to raise cash to pay the investor, this potentially increases capital gains exposure.
- Trades like a stock - You can buy and sell an ETF throughout the day, its price fluctuates like a stock. Mutual Funds can only be purchased or redeemed at the end of the day.
Stephen Rischall, CRPC