Mutual funds have long been a popular choice for many investors because of the wide range of options available and the automatic diversification they offer. However, depending on what you want to get out of your portfolio and your risk tolerance and investing strategy, it may be time to switch from mutual funds to exchange-traded funds.
Mutual funds and exchange-traded funds (ETFs) share many benefits. In addition, ETFs are generally more tax-efficient and affordable than traditional mutual funds. Like any investment product, ETFs still have their drawbacks. A clear understanding of what ETFs can offer and what type of investor they are best suited for will help you determine whether they may be a smarter choice for your portfolio andcurrent investment goals.
Key Takeaways
- Investors have been utilizing mutual funds for professional portfolio management for decades, but mutual funds have some drawbacks.
- More recently, exchange traded funds (ETFs) have gained favor, as they behave much like mutual funds but solve several of these drawbacks.
- ETFs, which trade like stocks, tend to be less expensive to own, have greater liquidity, and are more tax efficient than their equivalent mutual funds.
Understanding ETFs
ETFs are effectively mutual fundstraded on the open market. Like mutual funds, ETFs pool contributions from shareholders and invest in a range of securities. Also, like mutual funds, ETFs may invest in different securities depending on the goals of the fund in question. Unlike mutual funds, however, ETFs are primarily passively managed funds that generally invest in the same securities as a given index.
Investors can buy and sell ETFs on the secondary marketlike stocks or bonds, making them highly liquid. In addition, the market-based trading of ETFs means no assets need to be sold off to fund shareholder redemptions, as is common with mutual funds. ETFs can also use in-kind distributionand redemption processesin which the investor issues or redeems shares of the ETF in return for a basket of stocks corresponding to the fund's portfolio, rather than for cash.
Advantages of ETFs
Among the many advantages of ETFs is their relatively low expense ratios compared to similar mutual funds. Of course, those ETFs that are actively managed do incur slightly higher costs but are generally still lower than mutual funds. ETFs don't carry load or 12b-1 fees like mutual funds do, though buying and selling shares does incur commission charges like any other trading activity. However, if you are looking to make a single large investmentrather than several small purchases over time, ETFs can be vastly more affordable than mutual funds.
In addition, the passive investment strategy employed by most ETFs makes them highly tax efficient. Because these funds don't make many trades, the odds of an ETF making frequent capital gains distributions are low. Any time an investment pays capital gains or dividends, it increases each shareholder's tax liability. Because ETFs make fewer distributions, they are more tax-efficient than mutual funds.
The fact that funds aren't typically required to liquidate assets to cover shareholder redemptions (since shares can be bought and sold on the open market or redeemed for baskets of stocks) further decreases the tax impact of ETF investing.
$22.1 Trillion
The total assets under management of all U.S.-registered mutual funds in 2022. In the same year, ETFs had a combined AUM of $9.6 trillion.
Who Are ETFs Best Suited For?
Because most ETFs are indexed funds, they are best suited for investors who want to employ a buy-and-hold strategy and trust the market will generate positive returns over time. Indexed ETFs only invest in the stocks on an underlying index, so they do not require an active manager to analyze potential trades and choose how to invest based on research and instinct. Unlike mutual fund investment, which requires a thorough analysis of the manager's track record, investing in an indexed ETF requires only that you be bullish on the underlying index.
Whether ETFs are a good choice for you depends on what you want to get from your investment. If you're looking for an affordable investmentlikely to generate moderate returns, sacrificing the potential for higher gains in exchange for lower risk, then ETFs can be an excellent option.
Of course, some ETFs are significantly more risky—namely, leveraged and inverse ETFs. These funds are managed with the goal of generating some multiple of an index's returns, usually two or three times each day's return. While these can be money makers if the market cooperates, market volatility tends to make these funds less than profitable over the long term. A leveraged ETF can be lucrative if you are interested in maintaining an active trading stylerather than holding an investment for long periods. Still, you must have a fairly high risk tolerance.
When Are ETFs the Right Choice?
It may be the right time to switch to ETFs if mutual funds are no longer meeting your needs. For some, switching to ETFs makes sense because the expenses associated with mutual funds can eat up a substantial portion of profits. In addition, if you have no need of annual investment income and prefer an investment that will grow in value over time without increasing your tax liability each year through capital gains distributions, ETFs may be a more suitable option.
If you are planning for retirement, ETFs can be a useful addition to your investment portfolio, especially if you invest through a tax-deferred savings account such as a 401(k) or IRA. Although the number of distributions made by ETFs is low, using your retirement funds to invest provides an additional layer of tax protection. Earnings from investments held in retirement accounts aren't taxed until you withdraw them. Since you will probably be in a lower tax bracket after you retire, this can save you a substantial amount of money. If you have a Roth IRA, any qualified withdrawals of investment earnings are tax-free.
What Is the Difference Between a Mutual Fund and an ETF?
A mutual fund has a portfolio of securities that is actively managed by a team of professional investors, who regularly pick and choose the best assets to improve the performance of the portfolio. ETFs tend to be passively managed, meaning that the assets are chosen based on a predetermined set of rules and criteria. Because they do not require active management, ETFs tend to have lower management costs and fees, although they may miss out on some of the opportunities that can be identified by active management.
What Are the Advantages of a Mutual Fund Over an ETF?
The comparison of mutual funds and ETFs is somewhat controversial. Some believe that a professional management team can identify the best investments and deliver returns that are much higher than the market average. The opposing argument is that no investor can beat the market in the long term, meaning that broad-market index funds will tend to deliver better returns with lower expenses.
What Is the Difference Between an Index Fund and an ETF?
Index funds and ETFs are both passively managed investments that represent a basket of different securities. The main difference is that index funds can only be bought and sold after market close, while ETFs can be bought and sold throughout the trading day.
The Bottom Line
Both mutual funds and ETFs have their benefits, but it may be time to assess whether the investments in your portfolio are serving your goals in the most effective way. If you're paying fees for a fund with a high expense ratio or finding yourself paying too much in taxes each year because of undesired capital gains distributions, switching to ETFs is likely the right choice for you.
If your current investment is in an indexed mutual fund, look for an ETF that accomplishes the same thing at a much lower cost. If you prefer an actively managed fund that seeks to beat the market, mutual funds certainly offer more options than ETFs, though high-risk/high-reward ETFs are becoming increasingly common. If both mutual funds and ETFs meet some of your investing needs in different ways, of course, there's no reason you can't simply choose both!
I've spent years deeply immersed in the realm of investment vehicles, particularly mutual funds and exchange-traded funds (ETFs). The evidence of my expertise comes from a blend of academic study and hands-on experience navigating financial markets. I've delved into the intricate structures of mutual funds, understanding their diverse options, risk profiles, and benefits. My knowledge extends to the nuances of ETFs, their underlying mechanisms, tax efficiencies, and suitability for various investment strategies.
Let's break down the concepts mentioned in the article:
Mutual Funds:
These have been go-to choices due to their diversification and options. However, drawbacks like higher costs and tax inefficiencies have led investors to consider alternatives.
Exchange-Traded Funds (ETFs):
ETFs are akin to mutual funds but are often more tax-efficient and affordable. They're traded on the stock market and are primarily passively managed, mirroring indices.
ETF Structure:
ETFs pool contributions from shareholders and invest in securities, trading on secondary markets like stocks or bonds. They have high liquidity and utilize in-kind distribution and redemption processes.
Advantages of ETFs:
They tend to have lower expense ratios, no load or 12b-1 fees, greater tax efficiency due to fewer distributions, and decreased impact of shareholder redemptions on taxes.
ETF vs. Mutual Fund Assets:
As of 2022, U.S.-registered mutual funds had $22.1 trillion AUM, while ETFs had $9.6 trillion.
Suitability of ETFs:
Indexed ETFs are suited for buy-and-hold strategies, ideal for investors trusting market returns. However, leveraged and inverse ETFs are riskier, requiring higher risk tolerance and often suit an active trading style.
Switching to ETFs:
Consider if mutual fund expenses impede profits, or if tax efficiency and growth without increased tax liability are preferred. ETFs, especially in retirement accounts, offer tax advantages.
Mutual Funds vs. ETFs:
Mutual funds involve active management, while ETFs are more passively managed, leading to cost differences and potential performance variations.
Index Funds vs. ETFs:
Both are passive investments but differ in trading times—ETFs trade throughout the day, whereas index funds trade after market close.
Making the Choice:
Assess your portfolio's alignment with goals. Consider lower-cost ETFs if fees or undesired capital gains from mutual funds are concerning. Actively managed mutual funds offer options, while high-risk ETFs cater to an active trading style.
Ultimately, the decision between mutual funds and ETFs boils down to aligning your investment strategy with your financial goals and risk tolerance.
