Mutual Funds or ETFs? Understand the Differences Before You Choose
DAN NEWMAN, CPA
Mutual funds have been around for nearly a century. Exchange-traded funds, or ETFs, are the newer kid on the block. The two investment types have much in common, but also have important differences that make each more appropriate for certain situations.
Passive or Active
ETFs have quickly assumed a prominent place in the U.S. investment landscape. In late 2014, more than $2 trillion in net assets were held in 1,400 ETFs, up from a single offering in 1993 and fewer than 100 in 2002. Despite this growth, mutual funds remain dominant. According to the Investment Company Institute, there are nearly $16 trillion of assets owned across about 8,000 mutual funds.
There are two basic types of mutual funds: actively managed and index-based. With actively managed funds, a portfolio manager decides which securities to buy and sell to give the fund the best opportunity to outperform a benchmark index. Index funds, however, are passively managed, meaning they are designed to replicate a benchmark’s characteristics and match its performance.
Despite a small number of actively managed ETFs, the vast majority are passive investments. They are designed to track a particular benchmark, making them most similar to index mutual funds.
Differences in Pricing
Even though index funds and ETFs share many characteristics, they also have significant differences. For starters, investors in mutual funds generally buy and sell shares directly from a fund company. The shares are priced once per trading day after the close of trading and investors must buy before then to receive that day’s price.
ETF shares, in contrast, are transacted on stock exchanges via a brokerage account. Their prices fluctuate throughout the day based on supply and demand. This means that shares sometimes temporarily trade at a premium or discount to their underlying investment’s net asset value (NAV). If the gap between share price and NAV gets too wide, buyers or sellers theoretically emerge to bring the prices back in line. However, in practice, the price discrepancy can persist for days or even longer.
Another key difference is that, just as with stock trades, investors incur brokerage commissions each time they buy and sell ETFs. Thus, the more frequently you transact, the higher your cost of ownership. Buying mutual fund shares directly from a fund company is usually commission-free (although some funds do have sales charges or “loads”).
Because most ETFs are passively managed, they tend to have low expenses, especially compared with actively managed mutual funds. Index mutual funds also generally have low expenses.
Tax Treatment Varies
Most ETFs are tax-efficient, especially compared to actively managed mutual funds, because they are not required to make distributions. ETFs are also typically more tax-efficient than index mutual funds.
When index funds need to redeem shares, portfolio managers may have to sell stock to generate cash. This can create capital gains that are passed through to individual shareholders, even those who never sell their own fund holdings. Because ETFs are transacted privately between buyers and sellers, investors have significantly more control over their taxes.
However, it is important to note that, if you own mutual funds in a tax-advantaged retirement account, such as an IRA, your purchases and sales do not involve capital gains. Further, fund distributions do not result in tax.
Consider Your Goals
Both mutual funds and ETFs can help you achieve your investment objectives. However, both also carry risks, including the risk that they will decline in value and you will lose money that you have invested in them. Discuss your goals and risk tolerance with your financial advisor and he or she can help guide you on the most appropriate investment.
Sidebar: Consider Your Objectives
Your individual situation will determine whether you are best suited for an exchange-traded fund (ETF) or a traditional mutual fund.
If you want a chance to beat the market (by, for example, outperforming the S&P 500 index), you will probably want to consider an actively managed mutual fund. Of course, despite their best intentions, many active managers wind up trailing their benchmark because of higher expenses and other factors.
It is important to think about your investment goals and timing. If you plan to make small, regular investments for a long-term objective, you might be better off setting up an automatic investment plan with a mutual fund company. That way, your frequent purchases will be free of transaction costs. ETFs, meanwhile, may be more cost-effective if you are making a larger, one-time investment.
Consider the investment objectives, risks and charges and expenses of mutual funds carefully before investing. For this and other information about the mutual funds you are considering, please read the prospectus carefully before investing. Mutual fund investment values will fluctuate and shares, when redeemed, may be worth more or less than the original cost.
ETFs do not sell individual shares directly to investors and only issue their shares in large blocks. ETFs are subject to risks similar to those of stocks. Consider the investment objectives, risks and charges and expenses of ETFs carefully before investing. Investment returns will fluctuate and are subject to market volatility, so that an investor’s shares, when redeemed or sold, may be worth more or less than their original cost.
Taxable vs. Tax-Advantaged Accounts: Where Your Own Investments Matters
Most people prefer certain tax-advantaged accounts such as IRAs, 401(k)s or 403(b)s for their retirement or long-term goals. While some types of assets are well suited to these accounts, other types of investments make much more sense for traditional taxable accounts. Knowing the difference can help bring you closer to your financial goals.
Understand How Your Investments are Taxed
Where you own investments matters because of how they are taxed. Certain investments, such as stocks, can generate capital gains. Long-term capital gains—gains on stocks held for more than one year—are generally taxed at a maximum rate of 20%. In contrast, short-term capital gains, where the investment is held less than a year, are taxed at your ordinary-income tax rate, which currently maxes out at 39.6%.
Some types of investments generate dividend income. You will need to pay attention to the tax rules for dividends, which belong to one of two categories:
- These dividends are paid by U.S. corporations or qualified foreign corporations. Assuming you have met the applicable holding period requirements, qualified dividends are taxed similar to long-term gains, currently maxing out at 20%.
- These dividends, which include most distributions from real estate investment trusts (REITs) and master limited partnerships (MLPs), receive a less favorable tax treatment. Similar to short-term gains, nonqualified dividends are taxed at your ordinary-income tax rate, which currently maxes out at 39.6%.
Tax-Efficient Options: One of Your Best Bets
Investments that lack tax efficiency are normally best suited to tax-advantaged vehicles. Conversely, the more tax efficient an investment, the better it is suited for taxable accounts.
Municipal bonds (“munis”), either held individually or through mutual funds, are one of the most tax-efficient investments you can own. Their income is exempt from federal income taxes and sometimes state and local income taxes as well. Because you do not get a double benefit when you own an already tax-advantaged security in a tax-advantaged account, holding munis in your 401(k) or IRA could result in a lost opportunity.
Similarly, tax-efficient investments such as passively managed index mutual funds or exchange-traded funds, or long-term stock holdings, are generally appropriate for taxable accounts. Over time, these securities are more likely to generate long-term capital gains, whose tax treatment is relatively favorable. Securities that generate more of their total return via capital appreciation or that pay qualified dividends are also better taxable account options.
Take Advantage of Income in the Right Way
Some of the best investments to hold tax-advantaged accounts are those that tend to produce much of their return in income, for one. This category includes corporate bonds, especially high-yield bonds, as well as REITs, which are required to pass through most of their earnings as shareholder income. Most REIT dividends are nonqualified and therefore taxed at your ordinary-income rate.
Actively managed mutual funds are another type of investment where it is more beneficial to hold in a tax-advantaged account. These funds tend to have significant turnover, meaning their portfolio managers are actively buying and selling securities, which typically creates short-term gains that ultimately get passed through to you. As short-term gains are taxed at a higher rate than long-term gains, these funds would be less desirable in a taxable account.
Beyond Tax Implications
The discussion above contains suggestions for taxable and tax-advantaged accounts. However, your situation might require a different approach. For example, you may need more liquidity in your taxable account than you do in your 401(k) account. In this case, you might decide to hold a high-turnover equity fund or high-yield bond investments in the taxable account because you value flexibility more than favorable tax treatment.
With any investment strategy, make sure to keep in mind the benefits and risks, including the risk that your investments may lose value. Ask your financial advisor to help you make the best choices for your situation.