When Should You Choose ETFs over Mutual Funds?
What does “SPY”, engineering during WWII, and spiders have in common?
If you have no idea, you are not alone. This is a tricky question. And the answer is a name you probably won’t recognize.
Nathan Most was born in Los Angeles, CA in 1914. He worked for the US Navy as a physicist and an engineer specializing in acoustics during World War II. After the war, he tried trading at the Pacific Commodities Exchange before joining the American Stock Exchange in the mid-70’s.
It was there that Most came up with a new idea for a mutual fund that would trade just like a stock.
As many other innovators, Most was initially met with skepticism. It took several years and a stock market crash to pave the way for the first Exchange Traded Fund (ETF) to get introduced. It was modeled to follow S&P 500 and got the ticker symbol “SPY” (see what we did there?) The full name of the first-ever ETF was Standard & Poor's Depositary Receipts, which was shortened to SPRD (or “spider” in colloquial-speak).
OK, no more puns. In all seriousness, Most’s invention and perseverance have started a movement and a whole new product offering. Today, the ETF market is worth $5 trillion (that’s 12 zeros at the end).
Which means that our clients often ask us about ETFs. Are they a good idea? Are they better than their predecessor, the old-fashioned mutual fund?
In order to answer those questions, we should begin by defining our terms.
ETF vs. Mutual Fund 101
Both ETFs and mutual funds are investments that can help diversify your portfolio. They are built to follow a blend of investments, which saves you the trouble of buying, selling, and monitoring individual securities that are inside those portfolios. By buying a unit (or a share) of an ETF or a mutual fund, you get to participate in the whole universe of securities that make it up.
ETFs and mutual funds share many similarities. Both track a blend of investments. Both are managed by a professional fund manager who chooses investments (although there could be differences between active and passive management). Both charge fees.
The two investment types also share some drawbacks, with the most important one being lower dividend yields. Because ETFs and mutual funds are built to mirror an index, they track a broader market — and the resulting earnings are “average”. If you were to hand-pick individual stocks, you could potentially experience higher gains that would come at the cost of higher risk exposure to dramatic losses.
However, there are also differences.
ETFs trade just like a common stock, which means that you could put in a buy order at 11AM on any trading day — and get that trade executed pretty close to the trading price you saw when you requested the trade. Mutual funds only get a once-per-day update to their value (which is referred to as NAV or Net Asset Value).
ETFs can track an index, a commodity, stocks, bonds, or a basket of investments. Mutual funds pool investor money and use it to buy a portfolio of stocks and bonds.
ETFs are typically less expensive than mutual funds.
ETFs are typically more tax-efficient, which makes them a better choice for a taxable account like a brokerage investment account.
As with everything investment-related, broad brushstrokes like the bullet points above should only be used to get your research started. Here are a few more points to add color.
When should you choose an ETF?
There are three scenarios that would typically favor an ETF over a mutual fund.
One, if you want lower minimums. ETFs are quite accessible to any investor. You could buy a share of an ETF for as little as $50, which allows you to participate in the market at a low entry cost.
Two, if you want more hands-on control over the price of your trade. Because ETFs trade like any other stock, you can do things like intraday orders, short selling, stop orders, and more.
Three, if you are looking to place an index-like investment in a taxable account. Each ETF has a tax efficiency index associated with it. Not all ETFs are created equal, and some index mutual funds can come close to the tax-efficiency of ETFs. However, if you are tax-sensitive, looking at ETFs is a good place to start.
When should you choose a mutual fund?
Does this mean mutual funds are completely outdated?
Not necessarily. There still are situations that call for using them.
For example, if you want to set up contributions or withdrawals to happen automatically on a schedule, you cannot do that with ETFs. So, if you are looking to invest additional funds monthly or quarterly (for example, with a periodic contribution to a traditional IRA), a mutual fund is the better choice.
Also, if your investment is doing to live in a tax-deferred account like an IRA or a traditional 401(k), a mutual fund may be the better choice because of capital gains distributions.
So, is it better to get ETFs — or mutual funds?
The ultimate answer is, “It depends!”
Remember that the universe of available ETFs and mutual funds grows all the time. The hard edge between the two products is difficult to define. In other words, ETFs and mutual funds exist on a spectrum, and no single one is universally “better” or “worse” than others. Your choice should be decided by the technical specs of the specific ETF and mutual fund you are considering, as well as by your goals and intentions for the investment.
Here is a list of questions you should ask to guide your research.
Which index or collection of underlying investments do you want to track?
How much money do you have to invest?
What fees are associated with each choice? Remember that many ETFs have trading commissions, so if you are planning to buy and sell them often, you should be aware of the potential for fee creep. Mutual funds do not have trading commissions, but they carry an expense ratio and other fees.
Are you intending to make additional contributions on a regular schedule?
What is the relative tax efficiency of each choice — and what type of account will house it? If you are looking for an investment to place in your taxable account, tax efficiency is more important than for a tax-deferred account.
Finally, is the fund manager following an active or a passive management philosophy — and what is his track record? At the end of the day, you will be relying on the fund manager’s judgment calls when it comes to monitoring, buying, and selling underlying investments.
Those are not easy questions, so be sure to work with a financial planner to make the optimal choice for you and your family!