Investors looking for an easy way to buy a diversified portfolio used to opt for mutual funds. Today, exchange-traded funds (ETFs) are an increasingly popular option offering several benefits.
Both vehicles invest shareholders’ combined money in a broad set of assets, which provides the safety of diversification without the stress of buying and selling individual stocks. But because of differences in how they are managed and traded, ETFs can be more flexible, cost-effective, and tax-efficient.
Mutual funds are actively managed, with a portfolio manager picking the investments and trying to beat the market. ETFs are passively managed to match the performance of a specific market benchmark or index. The makeup of the ETF portfolio matches the relative weight of stocks in the target index.
This means ETFs have lower management fees and expense ratios, and many have eliminated brokerage fees for trades. This all adds up to an economical investment, with an average expense ratio as low as 0.2%. According to Investopedia, the average expense ratio for actively managed mutual funds is between 0.5% and 1.0%.
ETFs are traded differently, too. They are bought and sold on exchanges like stocks at any time of day. This allows greater liquidity, as investors are trading shares directly with other buyers or sellers and can respond immediately to price.
Mutual funds, however, are traded through the fund manager and sold only at the end of the market day. The fund calculates the Net Asset Value—total fund assets minus liabilities divided by total shares—to set the price after the market closes, which makes it a bit less transparent to the shareholder. And some mutual funds require shares to be held for a set number of days and impose a penalty for selling early.
Lower Capital Gains Taxes
Another benefit of an ETF is lower capital gains taxes. In a mutual fund, when someone cashes out a position, the fund manager may need to sell shares to raise cash to cover the redemption. That sale generates capital gains and by law, mutual funds must distribute capital gains among shareholders annually. That means more buying and selling within the fund, and all investors bear the tax impact of these sales, even if they didn’t individually decide to sell.
For ETFs, investors face capital gains taxes only when they choose to sell shares. This is especially important if the ETF shares are held in a taxable account – and less so if they are part of a tax-exempt or tax-deferred portfolio. In either case, the capital gains are easier to plan for when they are triggered by your own decision to sell shares.
A Good Bet for Beginners
A final advantage of ETFs is that they typically have a low cost of entry; you can buy a single share if you’d like. Mutual funds often have a minimum required investment of $1,000 or more. If you only have a little money to invest and want to minimize taxes, ETFs may be the way to go.
There are specific types of ETFs with differences in the assets that can be held and the way dividends are paid. There are also index funds—mutual funds that are passively managed and track a benchmark—that offer some of the benefits of ETFs, with some differences. For help determining which type of fund best meets your needs, contact us.
- Toni L. Shears
Cathy Pareto, “Mutual Fund vs. ETF: What’s the Difference?”, Investopedia, updated Mar 18, 2020, https://www.investopedia.com/articles/exchangetradedfunds/08/etf-mutual-fund-difference.asp.
Ariel O’Shea, “ETF vs. Mutual Fund: What to Know Before Investing,” Nerdwallet, Oct. 9, 2020.
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