ETFs vs. Mutual Funds: Why Investors Who Hate Fees Should Love ETFs
Exchange-traded funds offer a huge cost savings to consumers over mutual funds. Here’s why, and a couple of quirks about ETFs to watch out for as well.
While the mutual fund universe is much larger than that for exchange-traded funds, more and more investors are discovering that they can save huge amounts in both fees and taxes and put more money in their pocket by switching to ETFs.
An ETF is a collection of usually hundreds, or sometimes thousands, of stocks or bonds held in a single fund similar to a mutual fund. But there are also a number of significant differences between the two.
When Comparing Fees ETFs Come Out Clear Winners
Numerous studies show that over the long term, managed mutual funds cannot beat an index fund, such as an ETF.
For example, according to the SPIVA scorecard, 75% of large cap funds “underperformed” the S&P 500 over five years through Dec. 31, 2020. Almost 70% underperformed over three years, and 60% over one year. And this is just the tip of the iceberg, with most other managed mutual funds — both domestic and international — underperforming their applicable index.
This is partly explained by the higher fees of managed mutual funds, which cut into the investor's return. According to Morningstar, the average expense ratio for a managed mutual fund in 2019 was 0.66%. Compare this to a well-diversified portfolio of ETFs, which can be put together with an average blended fee of 0.09%, according to ETF.com. Try getting a fee that low with mutual funds.
What makes the gap in fees even greater are the invisible transaction costs for trading securities inside a mutual fund. Due to the difficulty in calculating these invisible trading costs, the SEC gives mutual fund companies a pass in disclosing them to the consumer.
But University of California finance professor Roger Edelen and his team gave us a pretty good idea when they analyzed 1,800 mutual funds to determine the average invisible trading costs. According to their research, these costs averaged 1.44%. Keep in mind this is “in addition” to the average mutual fund expense ratio of 0.66% mentioned above.
An ETF, on the other hand, is cloning an unmanaged index, which generally has very little trading going on, and therefore these hidden trading costs are little to nothing.
Between the expense ratio and the invisible trading costs of a managed mutual fund, the total average expense is easily over 2% for mutual funds, which is over 20 times more than the typical expense of an ETF.
Tax Savings Are Another Win for ETFs
ETFs can also save the consumer money by avoiding taxable capital gains distributions that are declared by the mutual fund even when the investor has not sold any of their mutual fund shares. Mutual funds are required by law to make capital gains distributions to shareholders. They represent the net gains from the sale of the stock or other investments throughout the year that go on inside the fund.
Keep in mind this capital gain distribution is not a share of the fund’s profit, and you can actually have a taxable capital gains distribution in a year that the mutual fund lost money.
ETFs, on the other hand, do not typically trigger this sort of taxable capital gain distribution. The only time you have a taxable capital gain is when the investor actually sells his or her shares of the ETF for a profit.
They’re More Nimble Then Mutual Funds, Too
An ETF trades in real time, which means you get the price at the time the trade is placed. This can be a real advantage for an investor who wants to have better control over their price. However, with a mutual fund no matter what time of the day you place the trade you get the price when the market closes.
A Sticking Point to Consider: The Bid and Ask Elements of ETFs
While ETFs have many attractive advantages, a potential problem to look out for has to do with their bid-ask price structure. The “ask” is the price the investor pays for the ETF and the “bid,” which is normally lower than the asking price, is the price the investor can sell the ETF for.
Highly traded ETFs have a very narrow spread between the bid and ask price, often as little as a single penny. But a thinly traded ETF can have a much larger spread, which under the wrong circumstances could cause the investor to sell the ETF for as much as 4% or 5% less than they paid for it.
Mutual funds on the other hand, set their prices at the close of the market and investors pay the same price to buy and sell, so this risk is eliminated.
Another Point to Ponder: Premium or Discount
ETFs can trade at a premium or discount to its net asset value, or NAV. Simply stated, this occurs when it trades at what is usually a slightly higher price or a slightly lower price than the value of the ETF’s underlying holdings.
While most ETFs exhibit very small discounts and premiums, some, especially those that are more thinly traded, can stray further away from the true value of the underlying holdings. For example, if an investor bought an ETF that was trading at a premium well above its NAV, he or she could be subject to a potential loss if the price of the ETF moved closer to its NAV price and the investor needed to sell.
You never have to deal with this issue on a mutual fund because the shares are always priced at the NAV.
The Bottom Line
In spite of these potential disadvantages, for the cost-conscious investor who plans on holding his investments for a while, ETFs may be one way to reduce their fees, allow for more nimble trading and reduce their taxes compared with their mutual fund cousins.