A common question many investors ask is which is better – ETFs or mutual funds? Both are great tools for investors who don’t want to invest solely in individual stocks but still be in the stock market. When you look at how much investors have in mutual funds vs. ETFs you’d think the former would be better.
In fact, ETF holdings pale in comparison to their mutual fund brethren with ETFs totaling roughly $2 trillion in assets vs. $15 trillion in mutual funds. That being said, ETFs – the relative newcomer on the block beat out mutual funds in most instances. If you’re considering investing in mutual funds or ETFs, consider the following differences before making a final decision.
Similar Yet Very Different
In many facets, mutual funds and ETFs are very similar. Both allow you to invest in a basket of securities. That’s great for investors wanting to spread risk, track a certain index or create a dividend income stream. While ETFs tend to be more passive in nature and mutual funds more active that can be said 100 percent of the time.
The similarities between mutual funds and ETFs end there. This begs the question of how they are different. The first difference between the two comes down to trading. ETFs trade on an exchange like a stock. Thus, they trade throughout the day. A mutual fund, on the other hand, trades only once at the end of the day. While this may seem like ETFs are riskier, that’s not really the case.
Taxes play a key role in investing. When managed wisely, taxes can be mitigated though the opposite is also true. This is where an ETF approach is better – generally speaking. The role of taxes all comes down to control. You see, with a mutual fund the manager must sell out of holdings to cover for shareholder redemptions. For example, if a fund has $1 million in redemptions (people selling out of the fund) the manager must then sell holdings to cover for that. This creates a taxable event. Additionally, mutual funds also make year-end distributions to shareholders. In each circumstance, this creates a capital gain distribution.
ETFs are handled, for the most part, differently. Since they trade like a stock, you control when you sell it and thus creating a taxable event. Taken further, the IRS allows you to write off up to $3,000 in capital losses each year – when they’re greater than any gains you’ve experienced. You’re not able to take advantage of this with mutual funds though you are with ETFs – this gives ETFs a distinct advantage.
The one caveat to this tax issue is commodity ETFs. As they may hold the physical commodity, they can be considered similar to collectibles. This results in a special tax treatment that must be considered. I will add one way to help mitigate tax issues is to do your investing in a retirement account such as from an old 401(k) rollover or something similar.
Cost is another key element to investing. In many instances, an ETF is going to beat a mutual fund in terms of cost by quite a bit. In both instances there is an expense ratio – which are as it sounds – the expenses carried by the fund. Mutual funds, as of 2014, had an average expense ratio of .99% though it’s not uncommon to see some be twice that much. ETFs, on the other hand, have an average expense ratio of .44%, though it’s not uncommon to see some be at least half of that.
These expenses don’t cover the purchase price of the given investment either. You can buy mutual funds through their fund family though you can also through many discount brokers. However, it’s not uncommon to need to spend $50 on a commission to do so. ETFs, on the other hand, trade like a stock and usually have a much lower commission price. Many of the best discount brokers even offer commission-free ETFs to clients – meaning you spend nothing to buy or sell them. That’s not to say you should only invest in commission-free ETFs, but they can be worth considering.
Mutual funds and ETFs are justifiable investment vehicles to consider by most. In many instances, however, an ETF is going to be the better option to consider.
Author Bio: John Schmoll and Gary Dek, two former finance professionals, are the founders of BestDiscountBrokerages.com, a review website committed to researching and rating the best discount brokers online.
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