ETFs...Better than Mutual Funds?
If you’ve heard of exchange-traded funds (ETFs), but you’re not sure what all the fuss is about, you owe it to yourself to give them a look. As with traditional mutual funds, ETFs hold pools of securities in their portfolios and issue shares against those portfolios to outside investors. However, ETFs are structured much more elegantly than are their more established mutual fund brethren. This elegant design translates into a number of significant advantages that have led to an explosion in ETF popularity. Two of the more significant advantages generally associated with ETFs are costs and taxes. Let’s take a peek.
On average, mutual funds consume about 1.25% of their shareholders’ asset each year to defray fund operating expenses. In contrast, the average ETF skims (according to NASD data) only about one-third as much. Think saving .8% per year isn’t worth the trouble? Consider someone with $20,000 who invests half that sum in a mutual fund and the other half in an ETF having a similar investment objective. Assume that each fund generates returns of 10% per year before expenses. After 20 years, that mutual fund might have grown to around $53,500 while the ETF would weigh in at about $62,000, or 16% more. That’s real money, no? This example excludes the impact of taxes, but the point stands. Costs matter, and in this respect, ETFs win hands-down.
Taxes matter, too. In this regard, ETFs win again – by an even larger margin. Whereas mutual funds are required to pass their capital gains through to shareholders at least annually (so shareholders can pay taxes on them), ETFs are able to minimize or even eliminate the distribution of taxable gains altogether. In fact, many ETFs have never distributed any taxable gains to their shareholders. That does not suggest that ETFs can’t generate profits. They certainly can and do. It simply means that due to their structural superiority, ETFs are in a much better position to minimize their tax liabilities than are traditional mutual funds.
If there’s a catch, it’s that you must have a brokerage account in order to buy ETFs because ETFs trade like stocks. Therefore, normal
brokerage commissions apply. In today’s world of discount brokers, however, the nominal costs of buying or selling an ETF may easily be outweighed by a number of other advantages.
