Benefits of Investing in Exchange-Traded Funds (ETFs) Rather Than Mutual Funds
Exchange-Traded Funds and Mutual Funds are similar in many ways. They both provide investors with exposure to a large basket of diversified investments. Investors can usually find their preferred strategic niche with both Mutual Funds and ETFs. For example, there are Mutual Funds and ETFs that give investors exposure to the US stock market, foreign stock markets, bond markets, commodities markets and many other classes of investments to help you achieve your investment goals.
The main difference between the two is that Mutual Funds are usually actively managed and ETFs are passively managed. For example, if an investor wanted to invest in the US stock market, they could choose a Mutual Fund where fund managers hand pick stocks in the US market that they believe will perform the best over time. Alternatively, an investor could also invest in the US stock market with an ETF, where the basket of assets is predetermined and often fixed. In this example, it could be an ETF that tracks the S&P 500 benchmark. In this article, we will go over why it is more beneficial to invest in ETFs rather than Mutual Funds.
It may sound nice to have professional money managers looking over your assets, like in the case of Mutual Funds, but active managers rarely beat the market. In a study done by S&P Dow Jones Indices, researchers discovered that 86% of actively managed equity (stock) funds underperformed the market. So, if you were to invest in a passively managed ETF that tracked the exact movement of the S&P 500 (I.e. US stock market) you would outperform 86% of the Mutual Funds that invest in US stocks.
Fees (Expense Ratio)
The fees you pay for investing in a Mutual Fund or ETF, called the expense ratio, is often lower with an ETF. This is because it is easier and more cost efficient to manage an ETF. Large personnel is used for a Mutual Fund because many analysts and portfolio managers are needed to find the most profitable assets. ETFs have a fixed basket of assets so there are not a lot of decisions that must be made. As discussed in the section above, it is mostly likely not worth paying for professional management because they rarely beat the market.
Investors will most likely be subject to lower taxes when investing in ETFs rather than Mutual Funds. When you invest in a Mutual Fund, you do so by exchanging cash for shares of the fund. The fund will then invest that cash into stocks, bonds, commodities etc. You are then making a cash-for-shares exchange directly with the fund company, which will subject you to long-term capital gains taxes.
When you invest in an ETF, you exchange cash for fund shares, but the exchange is between you and an Authorized Participant (AP), not the fund company. First, an AP will purchase a basket of assets through the capital markets, which represents the assets that make up the ETF. Then, the AP delivers the securities to the fund custodian in exchange for shares in the ETF, known as ETF Creation Units. This exchange is done “in-kind.” Then, the AP will deliver you your ETF shares.
Because the exchange is “in-kind” and is between the AP and the fund custodian, you are less likely to be faced with long-term capital gains taxes. Although, when you sell your ETF, you will pay tax if there is a gain in the share price. The explanation is a bit complicated, but all you need to know is that you will most likely pay less taxes by investing in ETFs.
One major benefit of investing in ETFs is the convenience of being able to buy and sell shares during all trading hours. With Mutual Funds, your orders only go through after hours when the Net Asset Value (NAV) is calculated for that day. ETF prices fluctuate throughout the day and therefore trade like stocks. Although you should not trade ETFs at a high pace, especially when investing for retirement, it is convenient to be able to enter or exit your investment easily and know exactly where the value of your investment is during the day.
ETFs are quickly gaining ground on Mutual Funds because investors are becoming more aware of the numerous benefits they provide. In many cases, ETFs make for a better investment than Mutual Funds.