Should I Invest in ETFs or Mutual Funds?
When it comes to gaining exposure to industries, markets, and commodities from around the world, investors have thousands of options. The two most frequently owned investment vehicles that provide such diversified exposure are mutual funds and ETFs (exchange traded funds). But for an individual investor, which one makes more sense?
Mutual funds are baskets of investments offered by companies like Blackrock or Vanguard, which are actively managed to outperform, or passively managed to track a given index, such as the S&P 500 or U.S. large caps. They’re sold either directly or through a brokerage, and can have complex, multi-faceted cost structures.
The cost of ownership, or expense ratio, starts with the price of the fund, which is set when the US markets close each day, and is based on its net asset value (NAV). There can be a variety of additional fees too, such as transaction fees (charged by the broker), load fees (one-time commissions paid to the broker), management fees (to pay the traders managing the fund’s assets), and 12b-1 fees (which cover marketing and advertising for the fund). For a full breakdown of a mutual fund’s fees, you should read the fund’s prospectus, or work with trusted fiduciary to ensure you're getting the lowest cost share class.
ETFs are offered by the same institutions, but are usually passively managed. And whether actively or passively managed, they typically have a lower expense ratio than a mutual fund offering the same exposure. A drawback to ETFs is that unlike mutual funds, you can't set up automatic investments or withdrawals for them. Another big difference between the two is that mutual funds owned in taxable accounts distribute capital gains to investors each year they yield a positive return. Given the bull market we’re still galloping along in, these distributions have become an annual event. ETFs can earn dividends and interest payments too, but they behave more similarly to stocks, and typically do not pay out automatic cash distributions. ETFs owned in taxable accounts generally trigger taxable events when they are sold, which is at the discretion of the investor.
Once a year, generally in November and December, mutual funds owned in brokerage accounts tally the profits and losses from the fund’s holdings, and distribute cash payments to fund owners, minus administrative costs and fees. The date of this calculation is set by the fund issuer, and the distribution, either via check or electronically, occurs automatically. If the fund’s trading activity results in a net realized capital gain, those distributions are taxable. They can be either short or long-term capital gains, depending on how long the fund held the securities, and are taxed according to the investor’s marginal income tax bracket. On some occasions, funds may make a second “spillover” distribution early the following year. In either case, the distribution is taxable in the year it occurs.
Short-term capital gains (for securities held less than one year) are taxed as regular earned income, and are taxed at a top rate of 37%, or potentially 43.4%, depending on what happens with the Biden tax bill. Long-term gains (for securities held for at least a year) are taxed at a top rate of 20%, which is still a significant hit. Another potential issue is that because capital gains are added to your adjusted gross income, you could be bumped into a higher marginal tax bracket, phased out of itemized deductions and certain tax credits, or lose your eligibility for Roth IRA or deductible IRA contributions. This is why it's usually recommended to own mutual funds in tax-advantaged retirement accounts which can reinvest gains and avert potential tax issues.
Advantage: it depends!
If owned in a tax advantaged account, like a 401k or an IRA, mutual funds can add value to your portfolio. The expense ratio gap is closing, and actively managed mutual funds or low cost mutual funds can offer specific advantages, depending on the details of your financial plan. Conversely, for mutual funds owned in a taxable account, the expense ratio disparity between mutual funds and ETFs is locked in every year, and, along with the tax complications, can be a drag on your long-term outlook.
When we say invest better, we mean getting the right exposure, within the right structure, at the right price. And that doesn't always translate to simply getting the lowest price.
If you have any questions about mutual funds, ETFs, fees, or your portfolio, let us know. We'd be happy to answer any questions you have.
Adam K. Wright, CFA, CFP®
Adam guides the vision and implementation of Wright's fiduciary service approach, and directs the firm's client engagement, service integration, and investment management practices.
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