Mutual Funds and ETFs are very similar in some regards, and different in others. The purpose of this article is not to discuss the technical nuisances that distinguish the two investment vehicles. That topic would likely bore you to tears and is not very useful for most individual investors! Instead, we will focus on the key differences that actually impact your portfolio.
The key differences:
- Tax effects
- Expenses
- Tradability
Tax effects
When it comes to tax effects, ETFs usually reign supreme. When you own an ETF, the capital gains tax is likely to be deferred until you sell the ETF at a gain. This is not the case with mutual funds. With mutual funds, you can be required to pay tax on gains before you even sell the fund. In fact, if other holders of the fund sell their shares and it forces the fund manager to sell underlying holdings, this can be a taxable event for you! For this reason, ETFs allow you to more reliably estimate taxes for this year and defer taxes to a later date.
Expenses
On average, ETFs have lower expense ratios (the amount of ongoing expense paid to the fund company) due to their tendency to be passive index funds. Passive funds don’t typically have expensive fund managers and research teams. Additionally, mutual funds can be purchased through a broker or through the mutual fund company. ETF’s can only be purchased on an exchange. The fact that mutual fund companies offer to sell funds directly to the public, they often have expensive customer service departments. Mutual funds can have low fees like ETF’s, but you must look into the details to be certain you aren’t buying a much more expensive option. Any amount you’re paying in operating expenses for a mutual fund or ETF comes straight out of your return.
Another aspect of expenses is trading fees. This can be further broken down into brokerage commissions and bid/ask spreads. Most major online brokers have lists of funds that trade for $0 commission (for both mutual funds and ETFs). I highly recommend you consult this list when evaluating investments. Mutual funds have no bid/ask spread, while ETFs do. This cost is unavoidable when trading ETFs, stocks or bonds. However, this expense is likely to be relatively insignificant for buy and hold investors.
Tradability
ETFs can be bought and sold throughout the trading day, whereas mutual funds are priced and exchanged after the markets close.
To summarize, there are pros and cons to both mutual funds and ETFs. Both types have funds that are high quality choices for sensible long term investing strategies. However, due to the fact that the return investors actually earn is what they get to keep after taxes, Windward typically prefers tax efficient ETFs to mutual funds. The predictability and control ETFs afford when tax planning make them the preferred choice in more cases than not, in my opinion.
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