Hey everyone, it’s Finance Fridays again and I’m going to talk about a topic that comes up just about everywhere. It’s Exchange Traded Funds (ETFs) versus Mutual Funds. This concept may be difficult to understand for new investors, so I wanted to try to make it as easy to understand as possible. As such, I decided it needed a whole post.
Stock Photo from: Pixabay
So I’ve actually been meaning to write this post for a long time now, ever since my original post Talking the Talk, with its basic definitions. However, I kind of forgot about it. My bad.
So let’s look at the definitions again:
Mutual Fund: A registered investment company which pools capital for investment. Enables the investor to hold a portion of many different companies. (A common investment vehicle)
Exchange-Traded Fund (ETF): A registered investment company which pools capital for investment, similar to Mutual Funds, with some slight differences which may be beneficial to you depending on your portfolio and tax burden.
For the most part, they are pretty similar because they both represent pooled capital for investments.
In fact, usually, for the same fund, you can choose to use the mutual fund or use the ETF variant.
Ok, so what’s the difference?
The major difference between a mutual fund and an ETF is how they are sold.
The price of a mutual fund does not change during the course of a day. You buy the mutual fund at the end of the day at a certain price which has been set.
So for a mutual fund, what you see is what you get. If it’s priced at $50 at the end of the day, you buy at that price.
Exchange-Traded Funds (ETFs) on the other hand can change their value over the course of the day and can be bought/sold at any given time during the normal trade day. In this sense, they are bought and sold like stocks.
What this means is that if you chose to buy an ETF at a price of $50, but because of the change in value you may have bought it $50.01 or $49.99. This potential difference is called the spread and you would make a designation as to what spread is acceptable to you.
Is there something else?
Yes. In general, normal mutual funds are considered to have higher fees, including potential load fees and higher expense ratios.
However, if you stick to good funds, then the difference is pretty minimal, for example:
Vanguard Total Stock Market Index
Right on that link you can see it shows Admiral Shares and ETF, with fees shown here:
(Click to Enlarge)
In order to qualify for Admiral Shares then you need at least $10000 in the fund. However, both have expense ratios of 0.04% and have no load.
So, its doesn’t make much difference here.
Wait, I heard ETFs are more tax efficient, is that true?
Well yes.
ETFs are better suited to decrease or prevent capital gains.
A mutual fund redeems its share directly whereas an ETF is traded like a stock.
If you sell your ETF and someone else buys it, then the underlying securities are not “sold” to raise “cash”, just exchanged. No “cash” = no capital gains.
However, this difference only really becomes important when you are comparing to an actively managed fund, which is buying and selling funds all the time. If you are utilizing a passive fund, like the Total Stock Market Index I demonstrated above, the tax benefits probably aren’t that significant.
I see, anything else I should know?
Yes. Just throwing your money into a “tax efficient” ETF for the sake of being an ETF probably isn’t a great idea. Like anything, you should look at the custodian of the ETF.
For example, Vanguard is a huge company which is unlikely to go belly-up in the future. However, a small start-up ETF could potentially go under and have a liquidation event. This would cause a taxable event, which would be… unpleasant.
Ok, so what’s the take home message?
You guys probably aren’t going to like this answer… but here it is:
For a Boglehead (passive investor), whether you go ETF or Mutual Fund probably doesn’t really matter all that much. As long as there is no load, just opt for whichever has the better expense ratio.
That’s the reason my picture above is Apple Juice versus Orange Juice. They’re different, but both good.
However, if this is going to be a taxable account (investment account outside of a 401k, IRA, etc) then opting for an ETF variant of an index fund is more efficient as long as the fees are the same. This can get a difficult to evaluate if the ETF variant has a slightly higher expense ratio for whatever reason. It will be hard to predict whether being more tax efficient is more beneficial than a lower expense ratio.
Long story short: Don’t let all these acronyms scare you.
The most important thing to remember is to save early and save often. That is the single most important thing.
Following that, opt for the best low-cost index funds available to you. (The Philosophy and Index Funds) Stay away from Actively Managed Funds.
Then choose a portfolio and try to approximate it. Keep putting the money away and rebalance every year or so and let compound interest do the rest.
TL;DR
ETFs versus Mutual Funds is like Apple Juice versus Orange Juice.
They’re different, but both good.
However, if you’re talking about a taxable account (investment account outside of 401k, IRA, etc) then the ETF is likely better, for tax efficiency.
Overall though, this doesn’t matter as much as saving early and saving often and choosing to be a passive investor.
Then choose the best low cost index funds available to you, choose a portfolio, try to approximate it, rebalance every year, and let compound interest work its magic.
-Sensei
Agree? Disagree? Questions, Comments and Suggestions are welcome.
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