Funds

ETF or mutual fund — which is better?

Q.: I have read that one should always use ETFs instead of regular mutual funds and I’ve read one should never use ETFs and read that it doesn’t matter. What is your viewpoint on funds v ETFs?

—Ted in Nashville

A.: Ted, my viewpoint on most products is that context matters. A product that can be good for one situation can be bad for others.

Traditional open-end mutual funds and ETFs (exchange-traded funds) have a lot of similarities. At their core, each is a pool of cash assembled by selling shares of the fund to investors. That cash is then invested by the fund’s managers in securities based on the fund’s charter on behalf of owners of the fund. All of the owners of the fund’s shares are mutual owners of all the securities in the fund, hence the name “mutual fund.” Manager fees for ETFs are generally lower than traditional funds but you should not assume a particular ETF is less costly than a particular traditional fund. 

Both traditional funds and ETFs allow one to create a broadly diversified portfolio with almost any amount of money. You can get both types of funds at virtually any brokerage firm in America.

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There are costs when fund shares are bought or sold. For instance, if you acquire funds through an “adviser” who is acting as a broker, you may pay a sales charge. If you have an account at Fidelity, Vanguard or other large brokerage firm, you may pay a transaction charge when buying funds that are not run by that firm. Fidelity will typically charge you a fee to buy a Vanguard fund. No fund is free even if there is no trade fee to buy or sell a fund. I may explain why at later date.

The differences between traditional funds and ETFs that are most impactful are tax-efficiency and the logistics of buying or selling fund shares.

When the manager of a traditional mutual fund wants to change the securities in the fund, the manager will sell existing holdings either for a gain or a loss. If those transactions result in a net loss for the year, the loss is used to offset gains incurred in the future and shareholders are not immediately affected. If those transactions result in a net gain, those net gains must be distributed to the shareholders and reported to the IRS if held in a taxable account.

By contrast, when the manager of an ETF wants to change the securities in the fund, the manager may also simply sell existing holdings either for a gain or a loss but in many cases, they opt for a different method unique to ETFs involving something called “creation units.” I’m not going to get in the weeds on how that works exactly but it is a form of a like-kind exchange that does not trigger a sale. As a result, ETFs tend to be more tax efficient than traditional funds because they tend to make very small if any capital gain distributions. The process is not perfect and some ETFs, particularly ones that use leverage, can make substantial gain distributions and are far from tax efficient.

As for the logistics of buying or selling funds, traditional mutual funds are bought and sold directly with the fund manager at the net asset value (NAV). Transactions are only made at the end of the day.

Exchange-traded funds and are exactly that. Shares can be bought and sold on a national stock exchange throughout the day. Because every security in the fund is changing value throughout the day, there is usually a difference between the price you pay when you buy an ETF (or get when you sell) and the NAV of the underlying securities. Usually, this difference is small but when markets are volatile large unfavorable differences tend to appear.

In general, for taxable accounts, ETFs may have an edge due to tax efficiency. More active traders tend to prefer ETFs because they can trade during the day. For long term investors that do not trade often, both forms of fund can be good choices. With either, you want to know what exactly the manager will be doing with your money and what the costs are before buying.

If you have a question for Dan, please email him with ‘MarketWatch Q&A’ on the subject line. 

Dan Moisand is a financial planner at Moisand Fitzgerald Tamayo serving clients nationwide from offices in Orlando, Melbourne, and Tampa Florida. His comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some reader questions are edited to aid the presentation of the subject matter.

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