3 Reasons to Take a Closer Look at ETFs
Their low cost and transparency are admirable, but their tax efficiencies may take the cake.
Most people who invest after-tax dollars look for ways to boost their returns while reducing long-term expenses. That’s a big reason so many investors turn to mutual funds and ETFs; both options make it easy to buy a single investment and keep it for the long haul with lower costs than some alternatives.
But which investment option will net you the greatest results? While no one knows for sure, I recently interviewed Ryan Kirlin on the Stay Wealthy Podcast to get his take.
Ryan is an ETF expert and Head of Capital Markets for Alpha Architect who strongly believes ETFs will prevail over mutual funds in the long run due to three major advantages they have.
ETFs vs. mutual funds – what is the difference?
Before we dive into the advantages of ETFs over mutual funds, it’s important to remember that your hard-earned money should not be invested without an Investment Policy Statement (IPS) in place. An IPS guides how your money is being invested — even if you are a do-it-yourself investor — and helps to avoid dramatic, irrational changes to a portfolio.
With that out of the way, let’s explore how ETFs and mutual funds work.
An ETF, or exchange-traded fund, is a diversified basket of securities (i.e., stocks and/or bonds) that track an index, like the S&P 500. Because the research is done for you, purchasing one ETF lets you invest in an entire industry or a sector of the economy without having to purchase hundreds, if not thousands, of individual securities.
Funny enough, a mutual fund works similarly since it’s also a diversified basket of securities composed of stocks, bonds and/or other investments.
According to Kirlin, ETFs and mutual funds are largely governed under the same rules, but ETFs receive certain exemptions. The most glaring difference — and one that he thinks gives them an edge — is that ETFs can be bought and sold throughout the day. Mutual funds, on the other hand, can only be transacted once per day, after the market closes and the net asset value (NAV) is calculated.
The biggest benefits of ETFs
The fact that you can trade ETFs during the day is a big advantage compared to mutual funds, notes Kirlin, but maybe not for the reasons you think.
Kirlin says that, historically, mutual funds have played a much larger role in panic selling because they can only be traded at the end of the day. This can leave investors in a position where they feel they have to sell if they’re nervous about potential losses versus waiting to see how things pan out.
While it might seem like having the option to trade ETFs during the day would lead to more panic selling during a downturn, Kirlin says the opposite is true. Investors who have the option to trade intraday seem to be more inclined to wait it out because they know they aren’t restricted to one trading window. This means they wind up making the optimal decision with their ETFs, which is almost always the decision to do nothing.
“If you trade too much, you’re going to lose money in the long run,” says Kirlin.
In addition to intraday trading, here are some more benefits of using ETFs you may not know about:
ETFs are more transparent
Kirlin notes that ETFs are more transparent than mutual funds, mostly because ETFs have a “culture of transparency.”
While the SEC doesn’t require it, just about every ETF issuer posts the daily holdings for their funds on free, publicly available websites. Head to Alpha Architect or iShares, for example, and you’ll find the detailed holdings of every ETF they manage. Mutual funds, on the other hand, are only required to disclose their holdings quarterly.
When it comes to ETFs, daily reporting means you always have access to detailed information about your investments, which can help provide peace of mind.
ETFs come with lower costs
By and large, ETFs also tend to be lower cost than mutual funds — as in, they charge lower operational expenses. This means you will typically pay less to invest in ETFs than you would in comparable mutual funds over the long haul.
Kirlin says this is mostly because “ETFs are simply a better technology than mutual funds.”
They require less record-keeping and fewer employees to remain operational, so ETF providers can pass the cost savings onto you.
ETFs are more tax-efficient than mutual funds
Finally, Kirlin points to a Rob Arnott study concluding that ETFs are considerably more tax-efficient than mutual funds.
There are two main reasons for this. First, mutual funds are pooled investments. With a pooled investment fund, you are investing alongside hundreds — or even thousands — of other investors, but you are all treated as a single account holder. Therefore, if the mutual fund realizes capital gains in a given year, every investor who owns the fund in a taxable account is required to pay a portion of the tax. This means you can get stuck paying capital gains taxes in a year where you didn’t make a single transaction.
Second, most mutual funds are actively managed. Meaning, the fund manager is frequently buying and selling securities in an attempt to beat the market instead of simply trying to track a specific index. Not only is it impossible to consistently beat the market, but frequent trading creates regular tax consequences for investors who own the fund in a non-retirement account. And, paying taxes every year can be a huge drag on your long-term portfolio returns.
ETFs, on the other hand, give you the ability to let your money compound over long periods of time without that tax drag. Like a stock, you only pay capital gains tax when you sell some or all of your shares at a gain. Deferring the capital gains tax and allowing your money to compound without the friction of an annual tax bill can make a big difference.
How much of a difference is at stake? Arnott’s research shows that, on average, mutual funds create a 0.80% tax drag, compared to 0% for ETFs.
It’s important to note that if an ETF is held in a taxable brokerage account, the investor is still required to pay taxes on dividends and interest earned each year. They aren’t completely tax-free. But, as previously mentioned, capital gains can be deferred and the taxes can be realized when it’s the most optimal time for the investor.
Similar to doing Roth conversions to lower taxes in retirement, “You could sell ETFs that you’ve owned for 10 years in a low-income year,” says Kirlin.
It’s not hard to see why this difference is so important to consider when searching for the best investment solution.
The drawbacks of using ETFs
The advantages of using ETFs are hard to ignore, but that doesn’t mean they are a good fit for everyone. There are two major drawbacks to consider before plowing your money into these products.
First, because ETFs trade intraday like a stock, you pay a hidden fee every time you buy or sell. This fee is known as the bid-ask spread, often referred to as a measure of market liquidity. The size of the spread — and the fee — depends on the supply and demand of a particular investment as well as the time of day you are transacting. Meaning trading ETFs requires greater due diligence on your part to ensure fees are mitigated.
Second, most major custodians still don’t allow you to make regular, automated investments into ETFs. For example, if you want to contribute $100 to your investment account each month and automatically invest those dollars it into an ETF, it’s likely not possible. You would have to manually purchase your ETF(s) each month — and navigate around the bid-ask spread — when your $100 lands in the account. On the other hand, custodians typically make it very easy to set up an automated investing program into a mutual fund or basket of mutual funds. And, it’s widely known that automating your investments is one of the key ingredients to long-term financial success.
The bottom line
When you start to think of ETFs as a lower cost, more transparent cousin of mutual funds, it’s easy to see why you may need to give them a closer look. There’s a reason the ETF market has grown dramatically in recent years while the mutual fund market has remained mostly flat in terms of assets under management.
Make sure to consider how and if ETFs should play a larger role in your retirement portfolio — particularly if you’re maxing out tax-advantaged accounts and starting to invest after-tax dollars. The increased transparency and lower costs ETFs offer can be a big improvement to your bottom line, but the potential tax advantages could be even more important.
About the Author
Founder and CEO, Define Financial
Taylor Schulte, CFP®, is founder and CEO of Define Financial, a fee-only wealth management firm in San Diego. In addition, Schulte hosts The Stay Wealthy Retirement Podcast, teaching people how to reduce taxes, invest smarter, and make work optional. He has been recognized as a top 40 Under 40 adviser by InvestmentNews and one of the top 100 most influential advisers by Investopedia.