Why choose an ETF over a mutual fund?
ETFs have several advantages for investors considering this vehicle. The 4 most prominent advantages are trading flexibility, portfolio diversification and risk management, lower costs versus like mutual funds, and potential tax benefits.
Less paperwork equals lower costs. Most of the time. Transparency: ETF holdings are generally disclosed on a regular and frequent basis, so investors know what they are investing in and where their money is parked. Mutual funds, by contrast, are required to disclose their holdings only quarterly, with a 30-day lag.
For instance, some ETFs may come with fees, others might stray from the value of the underlying asset, ETFs are not always optimized for taxes, and of course — like any investment — ETFs also come with risk.
If you're paying fees for a fund with a high expense ratio or paying too much in taxes each year because of undesired capital gains distributions, switching to ETFs is likely the right choice. If your current investment is in an indexed mutual fund, you can usually find an ETF that accomplishes the same thing.
ETFs are generally considered more tax-efficient than mutual funds, owing to the fact that they typically have fewer capital gains distributions. However, they still have tax implications you must consider, both when creating your portfolio as well as when timing the sale of an ETF you hold.
ETFs can be more tax-efficient than actively managed funds due to their lower turnover and fewer transactions that produce capital gains. ETFs are bought and sold on an exchange throughout the day while mutual funds can be bought or sold only once a day at the latest closing price.
Mutual funds tend to be actively managed, so they're trying to beat their benchmark, and may charge higher expenses than ETFs, including the possibility of sales commissions.
While these securities track a given index, using debt without shareholder equity makes leveraged and inverse ETFs risky investments over the long term due to leveraged returns and day-to-day market volatility. Mutual funds are strictly limited regarding the amount of leverage they can use.
For most standard, unleveraged ETFs that track an index, the maximum you can theoretically lose is the amount you invested, driving your investment value to zero. However, it's rare for broad-market ETFs to go to zero unless the entire market or sector it tracks collapses entirely.
ETFs may close due to lack of investor interest or poor returns. For investors, the easiest way to exit an ETF investment is to sell it on the open market. Liquidation of ETFs is strictly regulated; when an ETF closes, any remaining shareholders will receive a payout based on what they had invested in the ETF.
Why are ETFs so much cheaper than mutual funds?
The administrative costs of managing ETFs are commonly lower than those for mutual funds. ETFs keep their administrative and operational expenses down through market-based trading. Because ETFs are bought and sold on the open market, the sale of shares from one investor to another does not affect the fund.
At least once a year, funds must pass on any net gains they've realized. As a fund shareholder, you could be on the hook for taxes on gains even if you haven't sold any of your shares.
The low investment threshold for most ETFs makes it easy for a beginner to implement a basic asset allocation strategy that matches their investment time horizon and risk tolerance. For example, young investors might be 100% invested in equity ETFs when they are in their 20s.
For most ETFs, selling after less than a year is taxed as a short-term capital gain. ETFs held for longer than a year are taxed as long-term gains. If you sell an ETF, and buy the same (or a substantially similar) ETF after less than 30 days, you may be subject to the wash sale rule.
ETFs have several advantages for investors considering this vehicle. The 4 most prominent advantages are trading flexibility, portfolio diversification and risk management, lower costs versus like mutual funds, and potential tax benefits.
As a result, ETFs may be the optimal vehicle for investors keen on managing their annual tax bills. Keep in mind, however, investors are also subject to capital gains tax if they earn a profit from trading their individual ETFs or mutual fund shares (i.e., selling for a higher price than they paid).
| Ticker | Fund name | 5-year return |
|---|---|---|
| SOXX | iShares Semiconductor ETF | 30.70% |
| XLK | Technology Select Sector SPDR Fund | 24.57% |
| IYW | iShares U.S. Technology ETF | 24.09% |
| FTEC | Fidelity MSCI Information Technology Index ETF | 22.79% |
Although similar to mutual funds, equity ETFs are generally more tax-efficient because they tend not to distribute a lot of capital gains.
One of the ways that investors make money from exchange traded funds (ETFs) is through dividends that are paid to the ETF issuer and then paid on to their investors in proportion to the number of shares each holds.
Index investing pioneer Vanguard's S&P 500 Index Fund was the first index mutual fund for individual investors.
Who should invest in ETFs?
That's right, passive investing with ETFs generally beats active investing. You don't want to analyze individual companies. If you have no desire to follow business, then pick an ETF or a few, and add to them over time. You're a new or intermediate investor.
ETFs can be a great investment for long-term investors and those with shorter-term time horizons. They can be especially valuable to beginning investors. That's because they won't require the time, effort, and experience needed to research individual stocks.
Even though they contain a basket of securities, ETFs are traded like a single security on a major U.S. stock exchange. ETFs can be bought and sold intra-day, just like any security. In contrast, mutual funds are priced and traded at the end of each trading day based on the fund's net asset value (NAV).
Too much diversification can dilute performance
Adding new ETFs to a portfolio that includes this Energy ETF would decrease its performance.
ETFs are often considered more tax-efficient as their structure minimizes capital gains distributions to investors. Meanwhile, mutual funds can generate capital gains within the portfolio which are distributed to investors, potentially resulting in taxable events.
