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
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.
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.
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.
Even if you hold a mutual fund throughout the entire year, the fund may distribute a capital gain in December that will cause you to pay capital gains taxes. However, because of their different structure, ETFs are much less likely to distribute capital gains to you at the end of the year. Therefore, your tax bill may be lower by owning an ETF instead of a mutual fund.
Another advantage of ETFs is that they trade all day long on a stock exchange, and you can get a price quote anytime the market is open. Mutual funds trade only once a day at the closing NAV price. ETFs give you more opportunities to trade, but it can be a disadvantage because you might be tempted to trade too often and hurt your long-term performance.
A third advantage is that ETFs generally have lower fees, or expense ratios, than mutual funds. That’s partly because ETFs are easier to administer for the fund company than a mutual fund. There also is more price competition between ETFs than in the mutual fund world. Those cost savings are passed along to investors.
I use ETFs in my practice for my clients because of the tax, trading and cost advantages over mutual funds.