For the first time, exchange-traded funds (ETFs) recorded annual net inflows of over $1 trillion in 2021. Although ETF assets have more than doubled since the end of 2018, they are still dwarfed by mutual fund assets due to their long-standing dominance in company retirement plans like the 401(k).
Let’s start by reviewing the similarities between ETFs and mutual funds. Both:
- Represent a collection of stocks or bonds
- Provide more diversification than a single stock or bond
- Offer exposure to a variety of assets classes
- Can be managed either actively or passively
ETFs are becoming increasingly popular with investors. While they may look just like mutual funds to the casual investor, their differences are important and can have a substantial impact on investment growth over time. Here are 5 good reasons to use ETFs rather than mutual funds.
1. ETFs cost less
There are several elements that comprise the total cost of an ETF or mutual fund including expense ratio, commission, and sales load. In addition to an inherently less expensive structure, ETFs tend to be passively managed rather than mutual funds that are more commonly actively managed leading to ETFs having a lower annual expense ratio than mutual funds. In most cases, other fees including commissions and sales loads are smaller or non-existent for ETFs.
According to the Investment Company Institute, the average mutual fund costs 0.50% of your assets each year ($50 annually for every $10,000 invested) whereas the average ETF has an expense ratio of just 0.18% ($18 annually for every $10,000 invested). Over long periods of time, even small differences in the expense ratio have a sizable impact on portfolio balances.
2. ETFs have higher returns
A recent report by S&P Dow Jones Indices showed that 94% of all actively managed domestic funds underperformed their benchmark over a 20-year period. Since most ETFs are passively managed and most mutual funds are actively managed, ETFs will generally have higher returns over time.
3. ETFs are more tax efficient
Shareholders of mutual funds have less control over when capitals gains are realized than do ETF shareholders. Mutual fund shareholders can even owe taxes on capital gains even if the mutual fund has decreased in value. Mutual funds incur capital gains by selling investments that have appreciated in value. These gains as well as any dividends are typically paid to shareholders in December. If you own mutual fund shares in a taxable account, you have limited control over the timing of when these gains are realized and you would owe taxes on these gains and dividends even if you didn’t sell shares and even if the mutual fund decreased in value. ETF shareholders have control over realizing capital gains and losses because they are a consequence of when they sell shares. You can expect to pay fewer taxes when owning ETFs than mutual funds.
4. No minimum purchase
Some mutual funds require a minimum purchase amount (often $2,000 – $3,000) to invest initially. ETFs have no such minimum.
5. More flexible trading
Mutual fund prices are set at the end of each trading day so any trades requested during the day won’t actually be fulfilled until the end of the day. Trading in ETFs is much more flexible and much more like a stock. You can trade ETFs any time the market is open and you can see the actual price in real time.
Although ETFs have incredible advantages in many cases, there are some good reasons to consider using mutual funds:
- Your 401(k) or other retirement plan offers only mutual funds. While ETFs are becoming more common in retirement plans, mutual funds are still far more prevalent.
- You make regular additions to your investments. A mutual fund can be a good option since you can automatically setup purchases of a fixed dollar amount.
- Similar ETFs are thinly traded – For ETFs that are less frequently traded, a mutual fund may offer more beneficial pricing.
- You want an actively managed fund. Since mutual funds are typically actively managed, they may work well for you if active management meets your financial goals.
- No ETF meets your specific needs. If you find a niche mutual fund that invests the way you like and you don’t find a comparable ETF, then the mutual fund may be a good fit.
Other factors to consider:
- Not all ETFs and mutual funds fit the generalities discussed above. For example, there are passively managed mutual funds and actively managed ETFs. You should carefully review specific funds you are interested in to see how they meet your specific goals.
- Some ETFs are thinly traded leading to large bid/ask spreads that could result in you paying a premium above the fund’s net asset value.
- You should consider the fees charged by your brokerage for the specific ETF or mutual fund you are considering.
- Tax laws and brokerage fees change so you should review them regularly.
White Pine Financial LLC is a fee-only Registered Investment Adviser. We recommend you review IRS publications and other reputable sources for more details on this subject. We also recommend you consult with your financial and tax advisor before making any decisions.