By William Hernandez, CFA, CFP
The battle between mutual funds and Exchange-Traded Funds (ETFs) is all but over. ETFs are standing in the victory circle with the investment world cheering from the stands, while mutual funds are suffering from waning investor interest. While mutual funds have a place in portfolios, in recent years ETFs have earned a reputation for being a better approach to long-term investing. Here are four key characteristics that clinched the ETF win.
1. Low Cost Options
ETF’s have won the battle against mutual funds as the low-cost security offering. This does not apply to all ETFs, but investors are reaping the benefits as most fund families cut fees. Mutual funds currently can’t compete on cost, due to the fact that mutual funds are saddled with additional administrative requirements. According to a Wall Street Journal article, the average expenses incurred inside mutual funds was 1.37% in 2014 while the equivalent ETF charged about 0.45%.1 Let’s consider this a different way, if you invested $100,000 into a mutual fund that returned 7% for 10 years, you would lose $1200 every single year due to internal costs in comparison to the average ETF alternative. This reduction in the portfolio means that you have less resources to build toward your long-term goal.
2. Tax efficiency
Mutual funds can sometimes contain what has come to be known as “phantom gains.” An extreme, but common “phantom gain” example is a situation in which a mutual fund is purchased in December, and even though the fund declines in price during the month, the investor receives a 1099 tax document indicating that he is responsible for capital gains built up in the years before he ever owned the fund. The reason this occurs is that the underlying investments in the mutual fund are not held to the same administrative requirements as the mutual fund itself and these underlying investments report gains and losses by different time frames. This administrative harness placed on mutual funds traps them into tax inefficiency. Even mutual funds designed to be tax efficient have trouble competing with typical ETFs.4 In contrast, most of the tax gains incurred by the ETF are generally controlled by the investor’s own buy/sell patterns in the ETF’s rather than a third party administrator.3 This means you control the timing of capital gains. Of course, everyone’s situation is unique, so please consult with your tax advisor before making investment decisions.
Transparency is one of the most obvious reasons for utilizing ETFs. On any given business day, the underlying weights and all holdings contained within an ETF can be downloaded daily. In contrast, mutual funds typically update their complete data on a quarterly basis. Additionally, ETFs have the ability to trade like a stock, meaning they can be bought or sold at the going price throughout the trading day. Mutual funds, on the other hand, are not valued (and cannot be traded) until the end of the day, potentially several hours after you have decided to make a purchase! This means that no matter what time of day you sell a mutual fund, the sale price will always be the closing value rather than the value at the time of the transaction. Lastly, ETF transparency means that timely metrics are available that can assist in the decision-making process of the ETF strategy. Accurate and current data is critical when navigating through the 8th year of a bull market. The bottom line is that ETF transparency allows for more efficient and informed trading opportunities.
Unlike mutual funds, ETFs trade throughout the day and their prices fluctuate accordingly. The pricing of an ETF closely tracks the price changes in its underlying securities. For most ETFs there is a highly liquid market, meaning that enough shares trade each day to satisfy buyers and sellers. This makes it possible for investors to execute buy or sell orders as soon as market conditions change. The pricing of an ETF is efficient because ETFs offer shares through a creation and redemption process. In other words, the number of outstanding shares may be increased or decreased daily as necessary to reflect demand. This is known as an “in-kind” exchange.
In general, ETF selections are a better option in comparison to mutual funds. While ETFs are much newer investment vehicles (introduced in 1993 vs. mutual funds dating back to 1924), they serve a valuable role in many portfolios today. ETFs were first created with the goal of providing investors with a simple, transparent trade in which verification of appropriate tracking was easily obtained. This sense of ease and minimalism have been two reasons for their growing popularity among institutional and retail investors.
As a side note, always do your research and verify that your investment selection is a true ETF. Today, there are hybrid securities known as Exchange Traded Managed Funds (ETMFs) that may look like an ETF, but lack the transparency so critical to its original ETF form. Pure ETFs provide an effective method to low-cost, tax-efficient, transparent, and liquid management of a portfolio. As with all investment decisions, always complete your due diligence and proper vetting before making a purchase.
2. According to bankrate calculator: http://www.bankrate.com/calculators/retirement/mutual-funds-fees-calculator.aspx
3. Leveraged and ETF’s containing derivatives are just a few exceptions
4. Wall Street Journal, Tax-Wise Fund vs. ETFs by Veronica Dagher