Most likely you have heard of ETF’s, also known as Exchange Traded Funds.
I am frequently asked what ETF’s are and how they differ from better-known mutual funds. In short, ETF’s are vastly different securities than mutual funds, and have many advantages over mutual funds.
ETF’s, like mutual funds are pooled investment vehicles, meaning investors can buy shares of a fund with each share representing an undivided interest in the underlying portfolio of assets that the fund holds.
Also, like mutual funds, the majority of ETF’s are regulated under the Investment Company Act of 1940, which provides important protections to investors including oversight by an independent board of directors, a requirement that fund assets be held separately from advisor assets and comprehensive oversight by government regulatory bodies namely the SEC.
This is where the similarities between ETF’s and mutual funds end. ETF’s have many advantages over mutual funds including greater tax efficiency, superior trading liquidity, better transparency and finally ETF’s almost always charge lower fees than mutual funds. While there are exceptions, a major distinction between a mutual fund and an ETF is the approach that the respective fund structures use in investing the fund’s assets.
Mutual funds take an active investment approach by seeking to earn greater returns than a specified index by picking individual securities that analysts and portfolio managers believe will outperform the index. ETF’s take a passive investment approach by investing in the underlying securities of a specific index with the goal of achieving similar returns to the index.
Let’s quickly examine the most important advantages ETF’s provide investors compared to mutual funds.
Greater Tax Efficiency
ETF’s are almost always preferable to mutual funds for taxable investment accounts because they generate less tax liabilities in the form of capital gains distributions compared to a similarly structured mutual fund. ETF’s generate fewer taxable events because of how they are structured to handle shareholder redemptions.
Paying capital gains tax on an unprofitable position is not simply unappealing it is a very inefficient way to grow wealth, yet a common scenario with mutual funds.
The primary reason ETF’s are more liquid than mutual funds is that they trade on an exchange intra-day. This means ETF shareholders may buy or sell their shares at the net asset value of the fund anytime throughout the trading day. Mutual fund shares can only be traded after markets close and the trades are executed directly with the fund provider instead of over an exchange.
ETF’s are generally more transparent than mutual funds because in most cases ETF’s provide transparency into underlying holdings daily versus a mutual fund that generally reports holdings quarterly. The daily transparency ETF’s provide makes it easier to evaluate and monitor the management of individual ETF’s. Additionally, ETF’s generally provide full transparency into the security selection and trading process and the security selection is systematic, meaning manager discretion does not really play a role in how an ETF is managed.
The most important fee difference between ETF’s and mutual funds is that ETF’s do not carry sales loads. Most actively managed mutual funds charge a sales load when shares are purchased, charging anything from 1% to more than 5% for simply having the pleasure of buying the mutual fund. Furthermore, mutual funds carry a management fee that is charged as a percentage of assets invested per year, according to Morningstar as of 2018 mutual fund management fees averaged .67% for actively managed mutual funds compared to .15% for ETF’s.
Replacing any mutual funds you hold with ETF’s is one of the easiest ways to improve your investment portfolio and dramatically reduce investment expenses.