by Donn J. Sinclair, MBA June 22, 2022
Exchange Traded Funds (ETFs) have become very favored investment vehicles in recent years. These ETFs built upon the advantages of their mutual fund cousins, and offer several distinct enhancements. On average ETFs may be even more tax efficient than mutual funds, plus the ETFs frequently offer lower fees and expenses. Another distinct advantage is their more flexible trading than indexed mutual funds.
ETFs normally boast two distinct tax advantages versus mutual funds. Mutual funds normally generate more capital gains taxes than ETFs. Of note also is that ETF capital gains are only incurred upon a sale; whereas, mutual funds normally pass on capital gains throughout the investor’s ownership. Frequently mutual funds will report capital gains distributions even when the investor has not sold any shares that year.
ETFs may have a tax downside to mutual funds. When ETF dividends are distributed within 60 days of the investor’s purchase, then those ETF dividends will be taxed at the investor’s current income tax rate. Of course for ETF IRAs, these tax differences are not a concern.
ETFs may be purchased through the market day as compared to mutual funds that may only be bought or sold once per day. The mutual fund purchase or sale must be placed while the market is open, and then that purchase or sale occurs after the market close. This transaction delay may result in a significant price difference between the order and transaction prices. For long-term investors this ETF intra-day trading flexibility should not be nearly as important; as this flexibility may be for those investors that trade more frequently. Another consideration is that the ETF trading flexibility may also incur higher trading costs than most mutual funds.
Probably the most important advantage ETFs hold over mutual funds are the lower ETF fees and expenses. Over the years lower cost investments tend to outperform those with higher expenses. These costs exist at some level for all ETFs and mutual funds, and these costs include management fees, custody costs, administrative expenses, marketing expenses, and distribution costs.
ETF investment costs are typically much leaner than their mutual fund counterparts. Frequently ETFs do not staff a call center for individual investor inquiries, and tend to have lower direct investor communication, marketing, and distribution costs. Plus, normally ETFs have no short-term redemption fees.
In summary, ETFs and mutual funds operate essentially the same. They both seek to accomplish investment objectives with pooled investor assets. There are numerous mutual funds and ETFs with the same objectives. There also is likely little difference in risk. ETFs and mutual funds with the same objectives, quite possibly will have similar investment risk.
The main difference between ETFs and mutual funds appears to be in the fees, expenses, and commissions charged. Typically ETFs have an advantage here over their mutual fund cousins. This advantage can be very important over a lifetime of investing and receiving retirement income.
Updated by Donn J. Sinclair
in Rock Hill SC and Charlotte NC
June 22, 2022
DJS: More information is available at IRS.gov.
See Publication 590-A and Publication 590-B.