by Donn J. Sinclair, MBA Personal Financial Advisor July 21, 2022
The popularity of Exchange Traded Funds (ETFs) continues to grow, and they have become very favored investment vehicles. These ETFs built upon the advantages of their mutual fund cousins, and now offer several distinct enhancements. ETFs may on average, be even more tax efficient than mutual funds, plus the ETFs often offer lower fees and expenses. Another distinct advantage is that ETFs feature more flexible trading than indexed mutual funds.
ETFs normally boast two distinct tax advantages versus mutual funds. Mutual funds normally generate more capital gains taxes than ETFs. Of note also is that mutual funds normally pass on capital gains continuously throughout the investor’s ownership; whereas, ETF capital gains are only incurred upon a sale. Often mutual funds will report capital gains distributions even when the investor has not sold any shares that tax year.
ETFs may have a tax downside to mutual funds. When ETF dividends are distributed within 60 days of the investor’s purchase, then those ETF dividends will be taxed at the investor’s current income tax rate. Of course for ETF IRAs, these tax differences are not a concern. You should discuss these tax features with your tax advisor, and your personal financial advisor.
Mutual funds may only be bought or sold once per day; however, ETFs may be purchased and sold through the market day. Although the mutual fund purchase or sale occurs at market close, the purchase or sale must be placed while the market is open. This transaction delay may result in a significant price difference between the order and transaction prices.
This ETF intra-day trading flexibility may be more important for those investors that trade more frequently, and not nearly so important for long-term investors. Another consideration is that the ETF trading flexibility may also incur higher trading costs than most mutual funds.
Probably the most important advantage ETFs hold over mutual funds are the lower ETF fees and expenses. Over the years lower cost investments tend to outperform those with higher expenses. These costs exist at some level for all ETFs and mutual funds, and these costs include management fees, custody costs, administrative expenses, marketing expenses, and distribution costs. Your personal financial advisor can help you compare these fees and expenses.
ETF investment costs are typically much leaner than their mutual fund counterparts. Frequently ETFs do not staff a call center for individual investor inquiries, and tend to have lower direct investor communication, marketing, and distribution costs. Plus, normally ETFs have no short-term redemption fees.
In summary, ETFs and mutual funds operate essentially the same. That is, they both seek to accomplish investment objectives with pooled investor assets. There are numerous mutual funds and ETFs with the same objectives, and there also is likely little difference in risk. ETFs and mutual funds with the same objectives, quite possibly will have similar investment risks and returns over the long-run.
The two main difference between ETFs and mutual funds appears to be in the fees, expenses, and commissions charged. Typically ETFs have an advantage here over their mutual fund cousins. Secondly, the ETF intra-day trading flexibility. These advantages may be very important over a lifetime of investing and receiving retirement income.
Updated by Donn J. Sinclair, MBA Personal Financial Planner
Updated in Rock Hill SC and Charlotte NC July 21, 2022
DJS: More information is available at IRS.gov.
See Publication 590-A and Publication 590-B.
