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.
![Choosing a happy face emoji from a pile of options.](https://cdn.mos.cms.futurecdn.net/bF4YPprxwSYhL4CjerT2XF-415-80.jpg)
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.
![https://cdn.mos.cms.futurecdn.net/hwgJ7osrMtUWhk5koeVme7-200-80.png](https://cdn.mos.cms.futurecdn.net/hwgJ7osrMtUWhk5koeVme7-320-80.png)
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
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.
Get Kiplinger Today newsletter — free
Profit and prosper with the best of Kiplinger's advice on investing, taxes, retirement, personal finance and much more. Delivered daily. Enter your email in the box and click Sign Me Up.
-
Visa Is the Worst Dow Stock Wednesday. Here's Why
Visa stock is down sharply Wednesday after the credit card company came up short of revenue expectations for its fiscal Q3.
By Joey Solitro Published
-
Another Analyst Moves to the Sidelines on Tesla Stock After Earnings
Tesla stock is spiraling Wednesday after the EV maker's big earnings miss and Wall Street has been quick to weigh in. Here's what you need to know.
By Joey Solitro Published
-
Confused by Annuities? Making Sense of the Different Types
Many investors aren't sure if annuities are a good option for meeting financial goals. Let's look at the different categories, along with their pros and cons.
By Kris Maksimovich, AIF®, CRPC®, CPFA®, CRC® Published
-
Talkin' 'Bout My Generational Wealth: Baby Boomers
With retirement, each generation has different priorities and challenges. For Baby Boomers, it's a matter of ready or not, here it comes.
By Alvina Lo Published
-
Stock Market Today: Stocks Tumble on Disappointing Big Tech Earnings
Poorly received quarterly results from Alphabet and Tesla sparked a steep selloff in equities.
By Dan Burrows Last updated
-
How to Avoid a Big Hassle if Your Financed Car Gets Wrecked
How an insurance check is made out for repairs can cause a world of problems if the lienholder is left out.
By H. Dennis Beaver, Esq. Published
-
Estate Planning Strategies to Consider as Election Nears
Are big changes in tax laws coming soon? Not likely, but you might want to take advantage of higher estate and gift tax exemptions well before the end of 2025.
By David Handler, J.D. Published
-
Stock Market Today: Mega-Cap Tech Rallies to Drag Markets Higher
Markets focused on upcoming earnings from Magnificent 7 stocks rather than chaos in D.C.
By Dan Burrows Published
-
How to Get Your Money's Worth From Your Financial Adviser
A good financial adviser will focus on how your financial planning and investment strategy align with your lifestyle and aspirations.
By Pam Krueger Published
-
Think of Prenups and Postnups as Financial Planning Tools
These contracts provide a clear framework for asset management and protection and are especially useful if you get married later in life.
By Andrew Hatherley, CDFA®, CRPC® Published