If you’re still using Mutual Funds and haven’t explored ETFs, then now may be the time.
An ETF is an Exchange Traded Fund. But what does that mean? If you are familiar with Mutual Funds then understanding ETFs will be easy. An ETF is simply just a bucket of stocks or bonds, just like a Mutual Fund is. However, that’s really where the similarities end.
We’ll talk more about ETFs vs Mutual Funds in just a moment.
You may recall the days of when Mutual Funds were the talk of the town. People were flowing money into these new-fangled products like they were going out of style. Mutual Funds were a way for people to affordably obtain a portfolio of thousands of stocks and bonds (i.e. a bucket of stocks and bonds). Fast forward to today and you will see the same phenomenon; people are flowing money into ETFs like they’re going out of style. In fact, ETFs are growing at a much faster rate than Mutual Funds did. According to Tom Steinert-Threlkeld of Securities Technology Monitor, it took Mutual Funds 50 years to grow to $1.0 billion whereas it has taken ETFs only 17 years. And according to ETF Trends, Bloomberg, ICI, and Factset, the amount of money in ETFs is expected to surpass Mutual Funds by around 2026.
Now, let’s talk about some of the advantages of ETFs over Mutual Funds:
ETFs are generally more tax-efficient than Mutual Funds. This is simply due to the way that ETFs are structured. Without getting too much into the weeds, ETFs have the ability to do exchanges instead of sales, thereby avoiding a capital gain (and subsequently a tax liability). Mutual Funds do not have this ability. Instead, they often times have to sell investments within the fund to free up cash. This is amplified when the stock market is crashing. People get nervous and want to cash out. The year 2008 is a classic example. During this time, many investor’s stock Mutual Funds lost 37% or more yet they still had to pay hefty amounts in taxes because everyone was getting out. Can you imagine losing 37% of your portfolio and then finding out that you also have to potentially pay thousands of dollars in taxes? You would not have been happy. ETFs help to shield you from this.
ETFs can be bought or sold at anytime during the trading day. In other words, you know their price at any given point during the day. Mutual Funds, on the other hand, can only be bought or sold at the close of the trading day, meaning that they are only priced at the end of the day. This is not really a big deal for long term investors.
ETFs are generally much less expensive than Mutual Funds. Mutual Funds are actual companies that have expenses and overhead. For example, they have an 800 # that you can call into and speak to their customer service representatives. They mail you statements and marketing literature. They have a website that you log into to see details about your investments. They have rent and utilities. All of these items are costly and as such investors in Mutual Funds share the burden. ETFs do not have these issues / costs since they are traded directly on a stock market exchange such as the New York Stock Exchange. In essence, a Mutual Fund is a middle-man, which is why they tend to be more costly.
ETFs typically do not have Style Drift. Style Drift is when an investment deviates from its objective. For example, you could own a Mutual Fund called the “Large Company U.S. Stock Mutual Fund”. Its objective is to purchase large company stocks within the U.S. However, the Mutual Fund manager may decide to own some international stocks to deceptively improve the Mutual Fund’s performance. As a result, you do not fully have the investment that you thought you purchased. Plus if you had purchased another international Mutual Fund, you would now likely have more international exposure than you desired. But the sad thing is, you likely wouldn’t even know it because you thought your U.S. Mutual Fund was simply U.S. stocks.
ETFs generally do not have Stock Overlap so long as you have different categories of ETFs. Stock Overlap is when you own the same stock within multiple investments. For example, you could own Google stock in all 3 of the Mutual Funds that you have. This would not necessarily be prudent diversification.
ETFs don’t have hidden trading costs. Did you know that the expense ratio publicly listed for a Mutual Fund is not the only expense you incur? Every time a Mutual Fund manager buys and sells a stock or bond, there is a trading charge associated. According to John Bogle of Vanguard, this fee averages 1.00%. This fee is in addition to the expense ratio and can only be found by looking in the Mutual Fund’s Statement of Additional Information. In other words, Mutual Fund companies DO NOT have to tell you about this hidden cost. This, unfortunately is a very deceptive practice of Mutual Funds. Additionally, when stocks and bonds are constantly sold within a Mutual Fund, not only does it increase your costs, but it also increases your taxation.
The results are clear – ETFs are a force to be reckoned with.
If you have any questions about ETFs vs Mutual Funds, feel free to Contact Us.
Brad Tinnon, Owner
CERTIFIED FINANCIAL PLANNER™
Photo courtesy of Nicole Jackson