When I first started investing in 1993, Exchange Traded Funds (ETFs) had just been introduced. They were not, however, a popular or widely known option. Instead, my options were primarily mutual funds or individual stocks. When ETFs were first introduced, they seemed pointless to me.
We were told they were a cross between mutual funds and individual stocks. Like Mutual funds, ETFs typically holds stocks of many companies, enabling investors to diversify easily and inexpensively. Like stocks, however, you can buy ETFs throughout the trading day and the price of an ETF share fluctuates when the market is open just like stocks.
But who cares? Do investors really need a mutual fund type investment that trades like a stock? Maybe not. There are, however, some distinct advantages that ETFs hold over mutual funds that make them a better alternative in many situations. So today we are going to look at 5 advantages of ETFs over mutual funds.
Advantages of ETFs
Advantage #1: Cost
The cost of mutual funds and ETFs is often ignored by investors, yet cost is one of the most important ingredients to investing success. Even small differences in cost can have a big impact on returns. If you don’t know the weighted average expense ratio of your investments, you need to figure it out now. It’s easy to determine the cost of your investments with free tools like Morningstar, or you can use a free tool like Personal Capital.
Now back to ETFs vs. mutual funds. The expense ratio of an ETF is typically lower than an identical mutual fund. Let’s look at an example. Vanguard recently launched an emerging market bond fund. It offers both an ETF and mutual fund version of the exact same fund. For the typical investor, the expense ratio of the mutual fund version is 0.50% (the costs go down if you have a lot of money to invest). In contrast, the ETF’s expense ratio is just 0.35%. In addition, the mutual fund charges a purchase fee of 0.75%, while the ETF does not (Note, the purchase fee is paid directly to the fund, but it’s still a fee each investor of the fund must pay).
There are brokerage fees that you may have to pay when purchasing an ETF. These fees, however, pale in comparison to a higher expense ratio for two reasons. First, in some cases you may not have to pay any brokerage fee for an ETF. If you have a Vanguard account, for example, you can purchase shares of Vanguard ETFs for free. Second, brokerage fees have come down so much over the past decade that they are practically irrelevant to all but the most active traders. In addition to Vanguard, I also use Scottrade which costs less than $10 a trade. There are many low cost brokerage options available.
Advantage #2: Taxes
One area where ETFs are the undisputed leader is in tax efficiency. Mutual fund trades are between the investor and the fund manager, which much sell the necessary dollar amount of stocks (unless the money is in cash) in order to pay the investor who is selling. This sale creates a taxable event for the remaining investors in the fund.
The purchase and sale of ETF shares, in contrast, are between investors just like the trading of stocks. In other words, the company behind the ETF doesn’t need to sell underlying shares or deplete cash reserves when investors head for the exits.
As a result, you could buy and hold a mutual fund and still have taxes to pay at the end of the year. If you buy and hold an ETF, you never pay capital gains taxes until you decide to sell (you still may owe taxes on dividends). You can use a tool like Morningstar to determine the tax efficiency of a mutual fund.
Advantage #3: Transparency
This is a great benefit because you know what you own at all times. That is to say, you always know the underlying securities in an exchange traded fund. In contrast, mutual funds report their holdings once a quarter. This advantage may not be critical to many investors of index funds, but it can be an important consideration for those considering an actively managed mutual fund.
Advantage #4: Trading
This advantage is not important for long-term buy and hold investors. It’s critical, however, for more active traders. With ETFs, just like stocks, you can enter and exit an ETF during the day to obtain a more favorable price. With ETFs you can use options strategies (such as covered calls), buy on margin and short. However just like the ability to trade intraday, this can be a negative as well because you may venture into a risky or complicated strategy that you otherwise wouldn’t have invested in.
The trading of ETFs raises a related issue. ETFs almost never sell at exactly the value of all the underlying stocks in the fund. If the ETF sells for more than the value of the bundle of stocks it holds, it’s said to be selling at a premium. If it sells for less, it’s said to be selling at a discount. For actively traded ETFs, these premiums and discounts typically are miniscule. Nevertheless, it is important to understand this aspect of ETFs before investing. In some cases, you may be able to buy at a small discount.
Advantage #5: Flexibility
ETFs enable investors to invest in almost anything. As Richard Ferri explains is his book, The ETF Book: All You Need to Know About Exchange Traded funds,
If you want to bet on the fortunes of pharmaceutical stocks or reginal banks, there’s an ETF for you. If you want to play the real estate market, there are multiple ETFs available for that purpose, investing in either domestic or international real estate. If you want to bet on companies that might find a cure for cancer or invest only in companies that don’t do business in Somailia, there’s an ETF for you. If you want to bet on companies known for innovation, ones that are leaders in their field, or ones that are followed by only a small number of analysts, there’s an ETF for you.
If you don’t know the cost of your investments, the first step is to figure out your weighted expense ratio. Then, compare the ETF alternatives to the mutual funds you already own to see how much money you can save by switching to ETFs. Be mindful of the tax consequences, and a call to your broker can help you wade through these issues.
Next: Expense ratios do not represent the total cost of mutual funds. Check out what other expenses you’re paying in How to Find The Hidden Cost of Mutual Funds.