If you look at your investment portfolio, you are bound to see two kinds of assets – if you have a diversified portfolio, that is. Those assets are ETFs and mutual funds. You’ve also probably heard a lot about them and maybe even heard people arguing over which is better. They both come with their own benefits and drawbacks that we will discuss in this article. Hopefully, you’ll come out with a better understanding of them and be able to make more informed decisions for your investment portfolio! If you work with a financial advisor already, you’ll have deeper insights into the rationale behind your advisor’s investment decisions.
ETFs are investment funds that hold a diverse bundle of assets, such as stocks or bonds. Usually, they are designed to track the performance of a specific index or market sector, providing investors with exposure to a wide variety of securities in one investment vehicle. One of the most significant differences between an ETF and a mutual fund is that ETFs are traded like stocks, meaning you can buy and sell them throughout the trading day, unlike a mutual fund. They are relatively new to the investing world – the first ETF didn’t hit the market until 1993 and didn’t catch on as a popular investment vehicle until the late 1990s and early 2000s as a potentially cheaper and more tax-efficient alternative to mutual funds.
Due to their unique structure, ETFs are typically more tax-efficient than mutual funds. ETFs accomplish this by distributing fewer capital gains distributions by utilizing in-kind exchanges rather than selling securities to raise funds.
ETFs can also use their baskets of securities to create a new ETF rather than selling the security and forcing a capital gains distribution. ETF tax benefits increase when purchased through a tax-advantaged account such as an IRA.
Essentially, you can purchase just one ETF and buy more as you see fit rather than putting down a sizeable chunk of money to invest in a mutual fund.
Some niche or specialized ETFs may have lower trading volumes, leading to liquidity concerns and wider bid-ask spreads. You may find yourself in need of cash and decide to sell off some ETFs to raise the necessary funds, just to find that your niche ETF isn’t selling on the open market right away.
Additionally, you have an increased chance of losing money due to a greater-than-average bid/ask spread. The wider the spread, the greater your ETF has to gain in value to begin making a profit. When accounting for brokerage fees on purchases and sales, you may find yourself losing money overall even though the ETF gained in value.
Some ETFs may not perfectly track their underlying index, resulting in a tracking error. For example, managers of an ETF may not realize that the proportions of the ETF are out of line with the index or perhaps don’t reach in time. An ETF’s returns may not match an index’s returns due to SEC diversification rules, transaction costs, and management fees.
Finally, an ETF may not fully replicate an index and opt for a sampling technique instead, meaning the ETF only holds the most influential securities in an index. Tracking errors tend to be small but may add up over time.
Mutual funds have been around much longer than ETFs, stretching back to 1924, with the arrival of the Massachusets Investors’ Trust. Mutual funds pool money from many investors to purchase a diverse array of stocks and bonds, just like ETFs. These funds are managed by professional portfolio managers who make investment decisions on behalf of the fund’s shareholders. They can be actively or passively managed, but more often than not, mutual funds are actively managed.
Mutual funds are bought and sold through the fund company at the end of the trading day at the net asset value (NAV) price, determined by the total value of the fund’s assets divided by the number of shares outstanding.
Now, you may be thinking that this is a disadvantage. After all, these were some of the advantages of ETFs. But these kinds of things dissuade investors from trying to time the market and promote a stay-the-course mentality vital for long-term investment success.
Buying and selling mutual funds at the end of the day prevents investors from panic selling during the daytime, giving the mutual fund time to go back up in price. Alternatively, it gives an investor time to calm down before the end of the trading day.
Mutual fund managers can use tax-loss harvesting strategies to reduce the taxable profit a mutual fund provides. Also, mutual funds are often the mainstays of retirement plans such as 401(K)s, which provide excellent tax advantages. So, if you have the choice of purchasing an ETF in a non-retirement plan or a mutual fund in a 401(K), the mutual fund may win out due to its tax-advantageousness, even if it comes with higher fees. This difference is felt even more if your company provides matching contributions. It’s hard to say no to free money!
Yes, this may be a good thing, depending on how you view it. But in times of crisis, you may be unable to cash out your mutual funds quickly. The chances of needing cash by the end of the trading day may be slight, but you should consider this when choosing between mutual funds and ETFs.
Overall, mutual funds are less tax efficient than ETFs as they create a greater amount of uncontrollable taxable events. For example, a portfolio manager may need to sell securities to align with the mutual fund’s prospectus, potentially triggering capital gains taxes.
If the underlying securities were held for less than a year, they might get charged at ordinary income rates, leaving you with a higher tax bill than expected. Also, mutual funds must distribute capital gains regularly, triggering another tax.
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