If you’re still using Mutual Funds and haven’t explored ETFs, then shame on you. Okay, okay….. That may not be completely fair since you may have never even heard of ETFs. So, let me back up and tell you what an ETF is.
An ETF is an Exchange Traded Fund. But what does that mean? If you are familiar with mutual funds then understanding ETFs will be easy. An ETF is simply just a bucket of stocks or bonds, just like a mutual fund is. However, that’s really where the similarities end.
We’ll talk more about ETFs vs Mutual Funds in just a moment.
You may recall the days of when mutual funds were the talk of the town. People were flowing money into these new-fangled products like they were going out of style. Mutual funds were a way for people to affordably obtain a portfolio of thousands of stocks and bonds (i.e. a bucket of stocks and bonds). Fast forward to today and you will see the same phenomenon; people are flowing money into ETFs like they’re going out of style. In fact, ETFs are growing at a much faster rate than mutual funds did. According to Tom Steinert-Threlkeld of Securities Technology Monitor, it took mutual funds 50 years to grow to $1.0 billion whereas it has taken ETFs only 17 years.
Now, let’s talk about some of the advantages of ETFs over Mutual Funds:
ETFs are generally passive investments while Mutual Funds are generally active investments. I plan to write on this subject in greater detail in a future blog, but the main idea is that passive ETF investments are typically more tax efficient and less costly than active mutual fund investments. This is primarily why we choose to use ETFs for our clients’ portfolios. For the remainder of this article, when mutual funds are mentioned, I am referring to actively managed mutual funds and when ETFs are mentioned I am referring to passively managed ETFs.
ETFs can be bought or sold at anytime during the trading day. In other words, you know their price at any given point during the day. Mutual Funds, on the other hand, can only be bought or sold at the close of the trading day, meaning that they are only priced at the end of the day. This is not really a big deal for long term investors.
ETFs are generally much less expensive than Mutual Funds. But why is this? Mutual funds are actual companies that have expenses and overhead. For example, they have an 800 # that you can call into and speak to one of their service representatives. They mail you statements and marketing literature. They have rent and utilities. All of these items are costly and as such investors share the burden. ETFs do not have these issues / costs since they are traded directly on a stock market exchange such as the New York Stock Exchange. In essence, there is no middle-man, which essentially is what a mutual fund company is. By the way, according to Morningstar, the average expense ratio for a mutual fund is 1.33% while the average expense ratio for an ETF is 0.40%.
ETFs do not have Style Drift. Style Drift is when an investment deviates from its objective. For example, you could own a Mutual Fund called the “Large Company U.S. Stock Mutual Fund”. Its objective is to purchase large company stocks within the U.S. However, the mutual fund manager may decide to own some international stocks to deceptively improve the mutual fund’s performance. As a result, you now do not have the investment that you thought you purchased. Plus if you had purchased another International Mutual Fund, you would now likely have more international exposure than you desired. But the sad thing is, you likely wouldn’t even know it because you thought your U.S. Mutual Fund was simply U.S. stocks.
ETFs generally do not have Stock Overlap so long as you have different categories of ETFs. Stock Overlap is when you own the same stock within multiple investments. For example, you could own Google stock in all 3 of the mutual funds that you have. This would not necessarily be prudent diversification. The ETF portfolios that we build for clients do not have any Stock Overlap. All of the stocks and bonds are truly unique, which we believe is the best way to invest.
ETFs are much more tax efficient than Mutual Funds. Those who own mutual funds within their non-IRA accounts will often times get hammered with taxes. The year 2008 is a classic example. During this time, many people’s non-IRA stock mutual funds lost 37% or more yet they still had to pay hefty amounts in taxes. Can you imagine losing 37% of your portfolio and then finding out that you also have to pay potentially thousands of dollars in taxes? You would not have been happy. This is generally not the case with ETFs due to the way that they are structured. ETFs are not completely shielded from taxation, but historically much less tax is owed on ETFs than on mutual funds. According to John Bogle, in his book “The Little Book of Common Sense Investing”, the average non-IRA mutual fund loses 1.80% to taxes. This is a phenomenal expense that could be eating into your return.
ETFs don’t have hidden trading costs. Did you know that the expense ratio publicly listed for a mutual fund is not the only expense you incur (if you recall from above, the average expense ratio is 1.33%)? Every time a mutual fund manager buys and sells a stock or bond, there is a trading charge associated. According to John Bogle of Vanguard, this fee averages 1.00%. This fee is in addition to the expense ratio and can only be found by looking in the mutual fund’s Statement of Additional Information. In other words, mutual fund companies DO NOT have to tell you about this hidden cost. This, unfortunately is a very deceptive practice of mutual funds. Additionally, when stocks and bonds are constantly sold within a mutual fund, not only does it increase your costs, but it also increases your taxation.
The results are clear – ETFs are a force to be reckoned with. As a firm we feel that ETFs give our clients the best chance for success due to the advantages listed above. Plus, one of the most important pieces of information, which I haven’t yet shared, is that the majority of actively managed Mutual Funds DO NOT outperform passively managed ETFs. So, why pay all the excess fees of Mutual Funds when at the end of the day they typically don’t outperform much less expensive ETFs.
If you have any questions about ETFs vs Mutual Funds, feel free to Contact Us. Or, if you would like to learn more about investing, then I invite you to check out our Investment Strategy, Investments We Use, and How We Build Portfolios. Here’s to making you a more “informed investor”.
Brad Tinnon, Owner
CERTIFIED FINANCIAL PLANNER™
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Photo courtesy of Nicole Jackson