Why are ETFs better than mutual funds?

By Investing, Tax Planning

An extremely brief history of mutual funds.

It used to be that individual investors could only buy shares in a company in “round lots” of 100 shares. If a stock was trading for $20, an individual would have to have $2,000 to invest in that company. Ordinary investors with only $10-15,000 to invest thus found it difficult to build a diversified portfolio.

Someone saw an opportunity to create a fund that would pool money from lots of individual investors so that the fund could build a well-diversified portfolio. Thus, mutual funds were born. Their growth and impact on investing was nothing short of revolutionary. It was a giant step in democratizing investing for the average person.

Exchange Traded Funds – ETF’s – are like Mutual Funds 2.0.

ETF’s and mutual funds are similar in that both bundle together hundreds or thousands of securities to offer investors diversified portfolios. They differ in several substantial respects, however.

First, as their name reveals, ETF’s trade throughout the trading day, allowing investors to buy and sell at any point in time – just like shares in Exxon Mobil or Apple. Shares in mutual funds can only be purchased or redeemed after trading has closed for the day and the Net Asset Value of each share has been calculated.

Second, ETF’s have lower operating expenses and thus charge significantly lower fees to investors. The average expense ratio for a stock mutual fund is 0.82% while the expense ratio for a stock ETF averages 0.09%. The mutual fund is nine times more expensive!

Third, many mutual funds have sales loads. ETF’s have none. Sales loads – sometimes as high as 5.75% at the purchase of a mutual fund and 0.25% each year thereafter – come out of an investor’s pocket and go straight to the investment adviser who sold them.

Fourth, mutual funds come with minimum amounts that an individual must invest. ETF’s have no investment minimums.

Lastly, ETF’s are significantly more tax-efficient. This is because when they buy or sell shares they are deemed to be “in kind” transactions that do not trigger a taxable event. When mutual fund managers trade shares in their portfolios, they trigger capital gains and losses for every one of their shareholders.

For all of these reasons, ETF’s are a smarter option for today’s investors. After all, it’s not about what you make, it’s about what you keep.