Mutual funds have long been a popular choice for many investors because of the wide range of options available and the automatic diversification they offer. However, depending on what you're wanting to get out of your portfolio and your individual risk tolerance and investing strategy, it may be time to switch from mutual funds to exchange-traded funds (ETFs).

Mutual funds and ETFs share many benefits. In addition, ETFs are generally more tax-efficient and affordable than traditional mutual funds. Like any investment product, ETFs still have their drawbacks. A clear understanding of what ETFs can offer and what type of investor they are best suited for will help you determine whether they may be a smarter choice for your portfolio based on your current investment goals.

ETFs: The Basics

ETFs are basically like mutual funds that are traded on the open market. Like mutual funds, ETFs pool contributions from shareholders and invest in a range of securities. Also like mutual funds, ETFs may invest in different securities depending on the goals of the fund in question. Unlike mutual funds, however, ETFs are primarily passively managed funds that generally invest in the same securities as a given index.

Investors can buy and sell ETFs on the secondary market just like stocks or bonds, making them highly liquid. In addition, the market-based trading of ETFs means that no assets need to be sold off to fund shareholder redemptions, as is common with mutual funds. ETFs can also use in-kind creation and redemption processes, in which the investor issues or redeems shares of the ETF in return for a basket of stocks that correspond to the fund's portfolio, rather than for cash.

Advantages of ETFs

Among the many advantages of ETFs is their relatively low expense ratios compared to similar mutual funds. Of course, those ETFs that are actively managed do incur slightly higher costs, but are generally still lower than mutual funds. ETFs don't carry load or 12b-1 fees like mutual funds do, though buying and selling shares does incur commission charges like any other trading activity. However, if you are looking to make a single large investment, rather than several small purchases over time, ETFs can be vastly more affordable than mutual funds.

In addition, the passive investment strategy employed by most ETFs makes them highly tax efficient. Because these funds don't make many trades each year, the odds of an ETF making frequent capital gains distributions are low. Any time an investment pays capital gains or dividends, it increases each shareholder's tax liability. Because ETFs make fewer distributions, they are more tax-efficient than mutual funds.

The fact that funds aren't typically required to liquidate assets to cover shareholder redemptions (since shares can be bought and sold on the open market or redeemed for baskets of stocks) further decreases the tax impact of ETF investing.

Who Are ETFs Best Suited For?

Because most ETFs are indexed funds, they are best suited for investors who want to employ a buy-and-hold strategy and trust that the market will generate positive returns over time. Indexed ETFs only invest in the stocks on an underlying index, so they do not require an active manager to analyze potential trades and choose how to invest based on research and instinct. Unlike mutual fund investment, which requires a thorough analysis of the manager's track record, investing in an indexed ETF requires only that you be bullish on the underlying index.

Whether ETFs are a good choice for you depends on what you want to get from your investment. If you're looking for an affordable investment that is likely to generate moderate returns, sacrificing the potential for higher gains in exchange for lower risk, then ETFs can be an excellent option.

Of course, some ETFs are significantly more risky – namely, leveraged and inverse ETFs. These funds are managed with the goal of generating some multiple of an index's returns, usually two or three times each day's return. While these can be money makers if the market cooperates, market volatility tends to make these funds less than profitable over the long term. A leveraged ETF can be lucrative if you are interested in maintaining an active trading style and making more frequent trades rather than holding an investment for long periods, but you must have a fairly high risk tolerance.

When Are ETFs the Right Choice?

It may be the right time to switch to ETFs if mutual funds are no longer meeting your needs. For some, switching to ETFs makes sense because the expenses associated with mutual funds can eat up a substantial portion of profits. In addition, if you have no need of annual investment income and prefer an investment that will grow in value over time without increasing your tax liability each year through capital gains distributions, ETFs may be a more suitable option.

If you are planning for retirement, ETFs can be a useful addition to your investment portfolio, especially if you invest through a tax-deferred savings account such as a 401(k) or IRA. Though the number of distributions made by ETFs is low, using your retirement funds to invest provides an additional layer of tax protection. Earnings from investments held in retirement accounts aren't taxed until you withdraw them. Since you will probably be in a lower tax bracket after you retire, this can save you a substantial amount of money. If you have a Roth IRA, any qualified withdrawals of investment earnings are tax-free.

Bottom Line

Both mutual funds and ETFs have their benefits, but it may be time to assess whether the investments in your portfolio are serving your goals in the most effective way. If you're paying fees for a fund with a high expense ratio or finding yourself paying too much in taxes each year because of undesired capital gains distributions, switching to ETFs is likely the right choice for you.

If your current investment is in an indexed mutual fund, look for an ETF that accomplishes the same thing at a much lower cost. If you prefer an actively managed fund that seeks to beat the market, mutual funds certainly offer more options than ETFs, though high-risk/high-reward ETFs are becoming increasingly common.

If both mutual funds and ETFs meet some of your investing needs in different ways, of course, there's no reason you can't simply choose both.

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