“ETFs vs. Mutual Funds”
Exchange Traded Funds or ETF’s are fairly new on the investing scene, at least in relative terms. ETF’s first came on the scene in 1993 while Mutual Funds have been around since the 1920’s. Since ETF’s began, there is an ongoing debate amongst investors as to which type of investment vehicle is better. For many aspects, mutual funds and ETF’s are quite similar. They both can hold hundreds of stocks (or bonds) inside of one ETF or Mutual Fund which means they both provide good opportunities for diversification. On the other hand, ETF’s have some preferential tax treatment and can be bought and sold throughout the day while mutual funds only execute trades at the close of business. We explore some misunderstandings about these investments and what to consider before making an investment decision.
Misunderstanding #1: Mutual Funds are more expensive than ETF’s
Before investors learned to pay attention to investment expenses, unfortunately high fees were the industry norm. Since mutual funds have been around longer than ETFs, they became associated with high expenses. But that is not always the case; it’s just the environment they were born into. Once the younger, newer Exchange-Traded Funds entered the investment scene, they became associated with low-cost investing. In contrast to the seemingly outdated mutual fund, ETFs were assumed to be inherently better because they were less expensive. Mutual Funds have caught up with the times however, and generally speaking they are now as low-cost as ETF’s, though they struggle to shed their old image. On the flip side, not all ETF’s are low cost. Very expensive ETF’s do exist if they are actively managed and especially if they are focused on international markets.
Misunderstanding #2: You Need an ETF to Shield you from Taxes
The second common misunderstanding is that you need ETFs to shield you from a big tax bill. As explained above, ETFs can shield you from some taxes that mutual funds can’t by deferring capital gains tax when they make a sale. However, this logic conveniently ignores that you can avoid the majority of taxes on your investments by implementing a simple buy and hold strategy. The longer you wait to sell an investment that has appreciated in value, the greater the tax advantage. That’s because selling your investment creates a taxable event (note: we are talking here about taxable accounts and NOT qualified retirement accounts such as 401K’s or IRA’s which have preferential tax treatment).
When you sell your investments, not only do you owe taxes, but you also incur transaction fees. (And remember, we want to keep our investment expenses low!) In short, when we invest, we want to limit our turnover. As investors, we want the funds that we invest in to behave the same way – limiting turnover to keep investment expenses low. This should be the case whether those funds are mutual funds or exchange-traded funds (ETFs). Frequent trading (or high turnover) not only generates taxes, but also creates other investing expenses. If those taxes don’t eat away at your investment return, the cost of frequent trading certainly can.
Should I switch to ETF’s For the Tax Benefit?
Like all good answers, it depends. Firstly, if we are talking about retirement accounts their tax deferred nature nullifies the argument. However, in a non-retirement account, switching from a mutual fund to an ETF is a taxable event. Since you would have to sell your mutual funds to exchange them for similar ETF’s then knowing your potential gains is an important first step. Additionally, simply switching to an ETF doesn’t guarantee you are going to get better results (see points above that there are ETF’s with high fees and high turnover as well). If you are currently holding mutual funds with little appreciation, high expenses, and high turnover, then the decision to switch to a low-cost ETF could be a good one.