ETFs versus Mutual Funds

Have you’ve been thinking, “Jeez, I really wish I knew what an ETF was.” Are you wondering if you should be investing in them instead of mutual funds? If so, keep reading…

To begin, the acronym stands for Exchange-Traded Fund. It’s an apt name because ETFs are a hybrid of a stock and a mutual fund.

• Like stocks, ETFs trade on a stock exchange during the business day. Mutual funds are typically bought and sold at their end-of-day “net asset value” (NAV).
• Like mutual funds, ETFs are portfolios of many stocks (or bonds). Typically, stocks are investments in a single company.

There are small differences between ETFs and mutual funds and these can translate into minor advantages and disadvantages for either one. Consider:

1. Trading fees

With ETFs, you incur trading expenses each time you trade them — maybe a commission and then a bid – ask spread. In most cases, they are insignificant and commissions have mostly disappeared. With mutual funds, you buy and sell shares at the NAV and do not incur either expense. Related to this, ETFs require you to have a brokerage account and enter a trade each time you want to buy or sell shares. There are different ways to trade and it is more complicated than buying mutual fund shares.

If you are making regular small investments (for example, ongoing payroll contributions to a 401K or IRA), ETFs are ill-suited as these expenses and trading hassles can become meaningful over time. Generally 401K plans do not even offer ETFs as an investment option.

Advantage: mutual funds

2. Operating expenses

Both ETFs and mutual funds incur operating expenses (known as the “expense ratio”). Most ETFs have low expenses while mutual funds have a wider range of these fees. In both cases, the fees are disclosed and there are comparable investment selections with comparable low fees for both of them.

Advantage: neither

3. Trading hours

With ETFs, you can trade whenever the stock market is open. With mutual funds, the transaction is always done as of the end of the trading day.

In theory, this is an advantage for ETFs; but in practice, most investors should avoid intra-day trading. You’re more likely to make rash and regretful decisions when offered that opportunity and you probably would have been better off had you done nothing instead of intra-day trading.

Advantage: neither

4. Pricing

With ETFs, there is no guarantee that the price at which you buy and sell is anchored to the NAV at that time. However, for technical reasons, any pricing variance should be insignificant. With mutual funds, you always buy and sell at the end of day NAV with no discount or premium.

Advantage: mutual funds (small)

5. Tax efficiency

ETFs can be more tax-efficient than mutual funds for technical reasons having to do with how capital gains are distributed. Compared to a well-managed index fund, this effect is insignificant. And, if you are investing in a retirement account, this is irrelevant as these taxes would not affect you.

Advantage: ETFs (small)

Bottom Line:

For most people in most situations — and especially in retirement accounts — use low-cost index mutual funds. They are easier to buy and sell and any ETF benefits don’t outweigh that. If your brother-in-law is extolling the virtues of ETFs, tell him there’s little substantive difference between them and low-cost mutual funds.