Mutual funds have long been a popular choice for many investors because of the wide range of options and the automatic diversification they offer. However, depending on what you want out of your portfolio, 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. But as with any investment product, ETFs have 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 good 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.
- Exchange-traded funds (ETFs) have gained favor over time, as they behave much like mutual funds but solve several of these drawbacks.
- ETFs, which trade like stocks, can 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.
ETFs are sold on the secondary market, which makes 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 actively managed ETFs incur slightly higher costs but are generally still lower than mutual funds. ETFs don't carry a load or 12b-1 fees like many mutual funds do, though some broker-dealers charge commission charges like any other trading activity.
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 as of 2022, according to Statista. 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 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 consume a portion of profits. Also, if you prefer an investment that will grow in value over time without increasing your tax liability each year through capital gains distributions, ETFs can be beneficial.
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 may 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?
Mutual funds and ETFs are very similar in that they can be passively or actively managed and mirror an index or strategy. The main difference between them is when they trade—mutual funds can only be traded after market hours, and ETFs trade throughout the day. ETFs generally have lower fees, but this isn't always the case.
What Are the Advantages of a Mutual Fund Over an ETF?
Realistically, it comes down to preference and what you're doing. ETFs can be used by traders to take advantage of price movements throughout the day. If you don't plan to trade throughout the day, a mutual fund might work better if you choose one with lower costs.
What Is the Difference Between an Index Fund and an ETF?
An index fund is any type of fund that mirrors an index by holding the assets listed on that index. The assets can be weighted to meet the fund's strategy—it's common to see a fund have more or less in some companies or sectors than its benchmark. An ETF can be designed as an index fund, but they don't have to be.
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 paying too much in taxes each year because of undesired capital gains distributions, switching to ETFs is likely the right choice.
If your current investment is in an indexed mutual fund, you can usually find an ETF that accomplishes the same thing. If you prefer an actively managed fund that seeks to beat the market, mutual funds certainly offer more options than ETFs, although actively managed ETFs are becoming increasingly common. If both mutual funds and ETFs meet some of your investing needs in different ways—as in they do not converge your portfolio's holdings but offer more diversity for it—there's no reason you can't have both.
