In recent years, we have heard mutual funds characterized as outdated and inferior to the newer type of pooled investment known as exchange-traded funds or ETFs. Are they?
ETFs are certainly newer and more innovative. New fund launches in recent years have overwhelmingly been ETFs as opposed to mutual funds. Mutual funds, by comparison, can look stodgy and outdated. Yet, despite being old-school, there are good reasons why mutual funds will continue to be the go-to investment vehicle for most individual investors.
Since the 1980s mutual funds have been the most common way for individual investors to gain exposure to the financial markets. Mutual funds are a type of pooled investment vehicle through which investors can obtain diversified exposure to stocks, bonds or other asset classes. Rather than buying individual stocks or bonds, a single mutual fund share can give an investor exposure to a broadly diversified portfolio.
ETFs are also a pooled investment vehicle. In fact, most ETFs are set up under the same legal structure as mutual funds. They differ from mutual funds, however, in one critical aspect: how they are traded.
Mutual funds shares are bought and sold directly with a mutual fund company. Mutual fund shares can be held in an account directly with the mutual fund company or a brokerage account, but in either case the underlying transaction is between the investor and the mutual fund company. Mutual fund transactions are processed once a day, after the close of market trading.
ETF transactions are very different. ETF shares trade on an exchange like stocks. An ETF trade occurs between two investors, one wishing to buy and the other wishing to sell. The ETF company is not a party to the transaction. Unlike mutual fund transactions, which are processed once a day, ETF transactions can be processed at any time throughout the day while the market is open. This is known as intra-day trading.
Trading flexibility. The relative ease and flexibility of intra-day trading is touted as a major advantage for ETFs, but in most cases the ability to trade intra-day is of little consequence to long-term investors. Over a long holding period, it matters very little whether your purchase was executed at 9:05 a.m. or after 4 p.m.
Moreover, trading ETFs raises complexities that don’t apply to mutual funds. With mutual funds, all transactions are executed at “net asset value” which is determined daily after the market close. The price paid for a mutual fund share always reflects the value of the underlying securities. Not so with ETFs.
ETF shares generally trade at a premium or discount to the net asset value of the underlying securities. If, for example, you buy an ETF at a premium, the amount paid in excess of net asset value is an additional cost. Likewise, if you sell an ETF at a discount, the difference between the discounted price and the net asset value is value lost. Investors trading in ETFs need to take account of the hidden costs associated with premiums and discounts.
Another hidden cost with ETFs is the bid-ask spread. The price at which an investor buys an ETF (the “ask”) is generally higher than the price at which an investor could sell that ETF (the “bid”). ETFs trading at a very narrow bid-ask spread (a penny, for example) are not a problem, but ETFs trading at wide spreads can mean higher costs for investors. To guard against having an ETF trade execute at an unintended price, most such trades should be placed using a limit order, not a market order, but that’s another discussion.
The advantage of intra-day trading is a non-issue for most long-term investors and the flexibility of intra-day trading comes at the price of additional complexities and potentially hidden costs.
Costs. Another claimed advantage is that ETFs are less expensive than mutual funds. That is largely true if comparing ETFs with most actively managed mutual funds. If the choice is between using a mutual fund with annual expense of 1% or an ETF with an annual expense of .20%, the ETF offers a clear advantage. If, however, the comparison is between an index tracking mutual fund and an index tracking ETF, the ETF is not necessarily the lowest cost option. These days, many index-tracking mutual funds compete head-to-head with ETFs on pricing. Many broad market index mutual funds and ETFs are available with annual expense ratios of less than .10%.
Tax efficiency. A third advantage claimed for ETFs is greater tax efficiency. Here, ETFs present a strong case, but one that should not be overstated. ETFs are certainly more tax efficient than most actively managed funds, meaning those funds which engage in individual stock or bond selection. During rising markets, these funds can make capital gains distributions that are taxable to the fund’s shareholders. For example, one U.S. stock fund reportedly made a 60% capital gain distribution to its shareholders in 2017, while the ETF fund tracking the same market segment, small cap growth stocks, made no capital gains distributions.
A better comparison, though, is between broad market ETFs and broad market index mutual funds. Both are extremely tax efficient. Many ETFs have made no capital gains distributions in many years, if ever, but the same is true of many broad market index mutual funds. Also, remember that tax efficiency is irrelevant in tax-deferred accounts such as retirement account where individual investors tend to hold most of their investments.
For all their merits, ETFs are not necessarily a superior choice over mutual funds. The best case for their use is probably when dealing with taxable brokerage accounts where tax efficiency is a priority. Hypothetically, there are situations where ETFs are the optimal choice over mutual funds, but in practice many broad market index mutual funds have provided essentially the same tax efficiency.
In tax-deferred retirement accounts, tax efficiency is not a consideration and it may not be worth it to take on the added complications associated with trading ETFs. All other considerations, including cost being equal, conventional mutual funds may be preferable.
Neither mutual funds nor ETFs should be painted with broad brushstrokes as being good or bad. They are simply investment tools to be used intelligently. Still, for all their stodginess, mutual funds will likely remain the primary investment vehicle for most individual investors.
David Peartree, JD, CFP® is the principal of Worth Considering, Inc., a registered investment advisor offering fee-only investment and financial advice. Offices are located at 160 Linden Oaks, Rochester, NY 14625, [email protected].