Exchange-traded funds (ETFs) and mutual funds are two great ways to dive into the world of investing. What are they? You can think of a mutual fund as a basket of stocks and bonds. Similarly, an ETF invests in a range of different securities but trades like a stock itself. So whether you want to invest in small, mid-size or large companies or in a particular sector, you’ll likely find a mutual fund or ETF that’s right for you. As you learn more about the nuances of ETFs and mutual funds, you should also seek the help of a financial advisor, who can help you guide you through the investment choices that will work best for your needs.
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Mutual Funds vs. ETFs: How Do the Costs Compare?
Looking at the expense ratio is the easiest way to gauge how costly an investment is. Expressed as a percentage, it refers to the amount of a fund’s assets that are used to cover administrative costs. The lower the expense ratio, the smaller the bite that’s taken out of your earnings.
In terms of the expense ratio, ETFs tend to have the edge because many of them track a market index and are passively managed. There are many index mutual funds, too. But many more are overseen by a fund manager.
Morningstar’s annual U.S. Fund Fee Study illustrates how wide the gap is between actively and passively managed funds. While the average asset-weighted expense ratio for active funds was 0.67% in 2018, the average ratio for passively managed funds was 0.15%.
Where Commissions Fit in
When youbuyor sellshares of a mutual fund or ETF through a brokerage firm, you’ll typicallypay a commission to your broker for each transaction. With adiscount brokerage, the fee can be as low as $7 per trade. But a full-service broker typically charges a much higher premium.
Whenyou’re choosing a mutual fund, you can get around the commission fee by buying directly from the mutual fund company. (Picking a no-load fund will also help you save.) With many ETFs, on the other hand, you don’t have that option. Since exchange-traded funds are traded like stocks, the fees can quickly add up if you’re executing multiple trades throughout the day.
Another advantage of ETFs is that they don’t have minimum starting balances. You can buy as little as one share, unlike many mutual funds. So if you don’t have a lot of money to play with, ETFs may be the way for you to go. Also, look for discount brokers with commission-free funds.
Tax Efficiency of ETFs vs. Mutual Funds
Aside from the upfront costs, investing in ETFs or mutual funds can have an impact on your bottom line at tax time. When the assets in a particular fund appreciate in value and those securities are sold, this results in a capital gain for the fund as a whole. Capital gains are then passed on to shareholders, typically in the form of a year-end distribution. Any gains you realize are subject to capital gains tax and depending on your income, you could end up owing more to Uncle Sam when you file your return.
Exchange-traded funds are usually considered to be more tax efficient because of how they’re structured. Passively traded ETFs typically have fewer capital gains distributions for individual investors compared to mutual funds.
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The Bottom Line
Between the two kinds of funds, exchange-traded funds are a more cost-effective choice when you consider the expense ratio and the tax implications. The fact that the initial investment can be lower only adds to their appeal. Just keep in mind that commission fees could cancel out your savings if you’re doing a lot of trading.
Investing Tips
- Regardless of whether you decide to invest in mutual funds or ETFs, you should stick to options that adhere to your risk tolerance. The key is to diversify your investments based on risk tolerance. You can use our asset allocation calculator.
- If you’d like to work with a financial advisor, we can help you find one. Use our SmartAsset financial advisor matching tool. Simply answer a few questions about your goals and the tool will link you with up to three local advisors. You can compare their qualifications and set up interviews before you decide to work with one.
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FAQs
The choice comes down to what you value most. If you prefer the flexibility of trading intraday and favor lower expense ratios in most instances, go with ETFs. If you worry about the impact of commissions and spreads, go with mutual funds.
What is the ETF tax loophole? ›
That means the tax hit from winning stock bets is postponed until the investor sells the ETF, a perk holders of mutual funds, hedge funds and individual brokerage accounts don't typically enjoy. The ETF tax loophole works only on capital gains, though.
What is the downside of ETFs? ›
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.
Are ETFs really more tax-efficient than mutual funds? ›
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. Internal Revenue Service.
Why buy an ETF instead of a mutual fund? ›
ETFs offer numerous advantages including diversification, liquidity, and lower expenses compared to many mutual funds. They can also help minimize capital gains taxes. But these benefits can be offset by some downsides that include potentially lower returns with higher intraday volatility.
Why would I buy a mutual fund instead of an ETF? ›
As we covered earlier, infrequently traded ETFs could have wide bid/ask spreads, meaning the cost of trading shares of the ETF could be high. Mutual funds, by contrast, always trade without any bid-ask spreads.
What is the 30 day rule on ETFs? ›
If you buy substantially identical security within 30 days before or after a sale at a loss, you are subject to the wash sale rule. This prevents you from claiming the loss at this time.
How do I avoid capital gains tax on an ETF? ›
One common strategy is to close out positions that have losses before their one-year anniversary. You then keep positions that have gains for more than one year. This way, your gains receive long-term capital gains treatment, lowering your tax liability.
Do I pay taxes on ETF if I don't sell? ›
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.
Has an ETF ever gone to zero? ›
Leveraged ETF prices tend to decay over time, and triple leverage will tend to decay at a faster rate than 2x leverage. As a result, they can tend toward zero.
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.
Which is safer ETF or mutual fund? ›
In terms of safety, neither the mutual fund nor the ETF is safer than the other due to its structure. Safety is determined by what the fund itself owns.
How long should you hold an ETF? ›
Holding period:
If you hold ETF shares for one year or less, then gain is short-term capital gain. If you hold ETF shares for more than one year, then gain is long-term capital gain.
Do you pay taxes on ETFs every year? ›
For ETFs held more than a year, you'll owe long-term capital gains taxes at a rate up to 23.8%, once you include the 3.8% Net Investment Income Tax (NIIT) on high earners. If you hold the ETF for less than a year, you'll be taxed at the ordinary income rate.
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.
Do you pay taxes on ETF if you don't sell? ›
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.
Is ETF good for long term? ›
Should I invest in ETF for the long term? ETF investing could help you grow money in the long run, thanks to the compounding power. They typically have lower costs than other types of investments. These benefits help you grow money over time.
Are ETFs a safe investment? ›
ETFs can be safe investments if used correctly, offering diversification and flexibility. Indexed ETFs, tracking specific indexes like the S&P 500, are generally safe and tend to gain value over time. Leveraged ETFs can be used to amplify returns, but they can be riskier due to increased volatility.
