What advantages do exchange-traded funds have over mutual funds?
ETFs are soaring in popularity, but don’t trade in all your mutual funds for exchange-traded funds just yet.
Between 2001 and July 2014, the number of ETFs climbed from 102 to 1,375, according to the Investment Company Institute, the trade association for the mutual fund industry.
Despite ETFs’ growth, low cost and tax efficiency, mutual funds still do some things better than their younger, more nimble brethren. And they still likely have a place in your portfolio.
Mutual Funds and Active Management
For fans of active management, mutual funds have a clear advantage: Most ETFs passively track an index rather than try to beat the market with unique strategies or prescient stock picking.
Here is a questions to answer, “is it better to invest your money passively, or invest your money with top management?”. I believe that in different areas, like large cap funds, passive is great, but in other areas (such as in Real Estate or Municipal Bonds), active may be better.
The firm Standard and Poor’s tracks the performance of actively managed funds versus indexes in its S&P Indices Versus Active Funds U.S. Scorecard and finds that the only category that shows persistent outperformance over time by active managers is the international small-cap equity sector. In the short-term, any number of sectors might do better than their benchmark indexes or they could all do worse. Consistently picking the right sector and fund is where advisers can earn their fees.
Benchmark outperformance can be found in certain sectors in the mid-size area and the small-size area and some international … but in big companies — IBM, Intel, the biggest 100 out there — you probably don’t need to spend the money on a manager…you could “just buy the index.
Mutual Funds Offer Unique Strategies
Mutual funds lend themselves more to unique investing strategies such as target-date funds. These are often designed as funds of funds with active strategies. Meanwhile, target-date ETFs tend to follow indexes.
In some cases, ETFs just don’t provide people with enough strategies if they are unsure of how to build a diversified portfolio. If you find a strategy that is unique and you find valuable, that might be a consideration in favor of choosing a mutual fund.
Target-date ETFs have another drawback as well: trading costs. Commissions will seriously erode returns when investors put money into a retirement account and dollar-cost average into ETFs over the span of many years.
No Commissions with Mutual Funds
Many mutual funds are available with no transaction fees and no sales commissions. On the ETF side, buying or selling most ETFs does incur a trading commission. That can make ETFs less than ideal for investors who are making regular contributions of small amounts of money.
If your commission is $7 or $8 and you’re only buying $500 of the investment, that is a big chunk of your total investment…in that case, you may be better to use a mutual fund (this may be especially true if you make monthly deposits to “dollar-cost-average”.
Assume someone invests $500 on a biweekly basis in both an ETF and a mutual fund. Both investments get 8 percent annual returns net of their expense ratio. The only difference is that the investor pays an $8 commission biweekly with the ETF. After 10 years, this is what the investor has accumulated in the two funds
On the flip side, ETFs allow investors to buy very small portions of the investment, which has benefits for investors who are just starting out with a small account.
Since ETFs trade like shares of stock, you don’t have to have a minimum investment like you sometimes have in mutual funds. It doesn’t make sense to buy one share of an ETF, but with many mutual funds you need $10,000 or more as a minimum initial investment. These small investors could avoid commissions altogether by seeking out no-commission ETFs (that are available at many discount brokerages such as Charles Schwab and Fidelity).
ETFs Offer Tax Efficiency
Mutual funds can be expensive when it comes to taxes. Even if the mutual fund isn’t trading a bunch of stocks as part of its strategy, the act of simply redeeming shares for outgoing investors can force managers to sell shares of the investments in the fund. Any taxes incurred from the sale are paid by shareholders at the end of the year. Even if you buy the fund late in the year, you could still be paying a tax bill for events that happened before you made the investment, thanks to what are known as embedded gains
As an example, you could buy a mutual fund today and lose $1,000. Let’s say you lose 10 percent. You could still have taxable gain at the end of the year. You’re inheriting the tax basis in those shares when you buy into a mutual fund. It may have fallen 10 percent after you bought in, but it may have been up 40 percent up prior to that. ETFs work more like stocks and your tax basis is whatever your tax basis is, not the ETF’s tax basis (you also don’t have to worry as much about year-end gain distributions and built in gains that happen especially in actively-traded mutual funds.
But taxes may not be the first thing to consider when choosing an investment. One thing I advise investors is never let the tax efficiency drive the investment decision…don’t let the “tax tail wait the dog”.
Also, the tax concern is a moot point when purchasing mutual funds within a tax-favorable retirement vehicle such as a 401(k) or an IRA, in which gains are not taxed.
Abundance of choices
If you have two products that are exactly the same, for instance, a mutual fund and an ETF that both track the Standard & Poor’s 500 index, then you can go down the list of other considerations, including the expense ratio, commissions and taxes.
Increasing numbers of investment choices are a double-edged sword for small investors. More choices mean that individuals can really get down into the nitty-gritty and implement a specific asset allocation plan with very low cost and incredible global diversity.
It also opens the door to all kinds of investing mistakes. Knowing the broad strengths and weaknesses of your investment tools is a great way to winnow the ever-growing field.
Having a diversified portfolio in order to minimize risk by buying shares of a mutual fund or an exchange-traded fund that is reflected to several companies under a market index, industry sector or market cap. So for instance, if you wanted to invest in the S&P 500 or a basket of large cap growth stocks, there is most likely a mutual fund or ETF for you. If you had to choose between a S&P 500 ETF or S&P 500 index mutual fund, what would be the advantages. Although they mirror the same index, here are differences:
- Fees: Fees for mutual funds are higher than ETFs because mutual funds have more operational and management costs. The expense ratio for mutual funds can typically cost anywhere from 1% to 2% and includes management fees, transaction fees, distribution fees, marketing costs and other expenses. You will pay even more if you are investing in a mutual fund that comes with a upfront sales load. Conversely, the expense ratio for an ETF is typically around 0.5%. ETFs do not have any 12b-1 or load fees, but you will pay a commission to buy or sell them.
- Taxes: Due to the different structures of ETFs and mutual funds, the tax consequences will also be different. With an ETF, you can decide when to take a capital gain or loss by selling it whenever you want. Because ETFs are traded on an exchange, no underlying stocks need to be sold to raise cash for investors who want to redeem shares. Although with mutual funds, the fund manager can sell securities at any time to rebalance the fund or accommodate other investors who want to redeem their shares. Even if the fund is losing money overall, shareholders will own tax on any gains from these sales.
- Accessibility: ETFs do not require an initial minimum investment like most mutual funds do.
- Trading Flexibility: In regards to trading, ETFs behave much like stocks. With mutual funds, you do not know what price you bought or sold them at until the end of day when the net asset value is calculated. Mutual funds trades only take one day to settle, in contrast to ETFs which take three days after the trade date to settle.
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.