The Benefits of ETFs Over Mutual Funds

Blue Mutual FundsIf you left a leaky faucet unrepaired, the eventual effect on your water bill would be noticeable. It might not be alarming over a single month, but over the course of years, that unrepaired drip would add substantially to your water bill. Incremental costs can add up.

This illustrates the most common argument for favoring exchange traded funds (ETF) over mutual funds. While mutual fund products are better known and have a much longer track record, the evolution of the ETF, since the late 80s, has been akin to shutting off that leaky faucet. Incremental costs can offset the gains made by account appreciation and impact retirement, or other savings totals, in ways that can be substantial.

Both ETFs and mutual funds hold a basket of securities, which can be equities or bonds. Many in the financial community have leaned towards the ETF product for several reasons. The open-end mutual fund has been the foundation of most retirement plans going back to the 1980s, and the product dates back to the 1930s, but the lower expense ratio has been winning converts to ETFs for several years now.

According to the Investment Company Institute, about 64 percent of 401k plan assets were held in mutual funds in 2014.

The ETF trades like a stock. Also, like a stock, an ETF can be bought on margin or sold short. The price of an ETF can be tracked throughout the trading day, unlike a mutual fund, which is priced at the end of the day. The ETF can be more tax-efficient than a mutual fund. Most of the taxes on gains is paid when the ETF is sold.

As mentioned earlier, both vehicles can hold a basket of securities. One popular feature of ETF’s is that the basket of securities can be in a single market sector or industry. Most ETF’s are index funds that focus on specific market segments. This helps make them more tax efficient as well. Also, there is less chance of owning the same stock in several ETFs because of the targeting of sectors. In a mutual fund, it’s possible to own the same security in multiple funds without easily noticing it.

Potentially Greater Costs
A mix of fees has been part and parcel of mutual funds since its creation. Those expenses can include marketing fees, shareholder accounting expenses at the fund level, management fees, salaries for a board of directors and load fees for sale and distribution of the fund. Funds that specialize in certain markets often have higher fees.

Mutual funds are required to distribute capital gains when the fund sells securities. In a mutual fund, it’s possible to have to pay taxes on capital gains even when the fund has gone down in value. With an ETF, the sales date is determined by the investor or their money manager.

The entry point for some mutual funds make diversification more difficult because that threshold may be very high. This is not the case with ETFs.

There is a possibility with an ETF, and their price swings during the trading day, that the intraday price changes could induce trading by someone who might otherwise not execute a trade with a mutual fund priced once a day.

Also, it helps to keep trading costs low to take full advantage of an ETFs lower overall costs. If trading costs are higher, then an ETF may compare more evenly with a low-cost index mutual fund. This comparison should be made to determine the lowest total cost.

With all the choices, the investor is the winner when they have access to lower cost alternatives.