Half of all households in the United States invest in mutual funds but it may be wise to consider exchange-traded funds (ETFs) as viable alternatives, too.
The Investment Company Institute’s 2016 Fact Book reported that U.S. investors have $15.7 trillion deposited in mutual funds and only $2 trillion in exchange-traded funds (ETFs). Yet, most investors would benefit from investing their money in ETFs, because ETFs offer more choices and more flexibility.
Access to exchange-traded funds has expanded since their introduction in the early 1990s. Some investors are using exchange-traded funds, but only as a small portion of their portfolio. However, a majority of investors continue to hold most of their investment assets in mutual funds and stocks.
Mutual funds have a role in an investment portfolio. But, exchange-traded funds have major advantages over mutual finds. These advantages make ETFs better financial instruments than mutual funds to invest your money.
What makes ETFs superior to mutual funds? Here are seven words to describe advantages of exchange-traded funds: simple, easy, inexpensive, transparent, variety, liquidity and taxes. Let me go through each of these and expand on what they mean for the average investor.
Investing in indexed mutual funds is a simple way to get exposure to a range of securities and to diversify your portfolio with a single investment. A majority of ETFs also are index-based funds. ETFs are a simple method to gain access to broad market sectors with a single investment as well. However, as you will see from the remaining points, ETFs have additional advantages that make them superior to mutual funds.
Like individual stocks, exchange-traded funds are easy to buy and sell. While you can buy and sell mutual funds just once a day, you can trade ETFs throughout the day. You can easily access exchange-traded funds through a single brokerage account.
Exchange-traded funds are inexpensive to buy, sell and own. On average, the cost of investing in ETFs is 75% less than the cost of investing in mutual funds. ETFs have a transaction fee to buy, but have none of the additional costs associated with mutual funds. Sales loads, commissions, exit fees, annual marketing or distribution fees and early withdrawal penalties are some of the costs you can encounter with mutual funds. Compared to mutual funds, exchange-traded funds are very cost efficient.
Mutual funds appear transparent because they provide lists of all their investment holdings and the respective allocations to each individual security. However, mutual funds report their holdings to the investors only four times per year. Exchange-traded funds are required to report all individual security holdings daily.
While you can choose from many mutual funds, exchange-traded funds offer choices inaccessible through mutual funds. The Investment Company Institute’s 2016 Fact Book reports almost 1,600 exchange-traded funds were available in the U.S. market at the end of 2015. In addition to equities, ETFs offer investment in commodities, currencies, international securities and fixed income.
You can buy and sell mutual funds only at the end of the trading day, However, you can trade ETFs throughout the day like stocks. Some small exchange-traded funds might be less liquid due to significant price spreads. However, large ETFs are easy to trade even if you use limit orders. Also, unlike mutual funds with early withdrawal penalties or exit fees, ETFs have no barriers to exit.
Even if a mutual fund performs well, taxes can reduce return on your investment significantly. Portfolio managers make changes to the holdings within the mutual fund regularly. Those changes create taxable events for the investors. In some cases, mutual fund shareholders can get a taxable event even when the mutual fund does not have any gains overall.
This potential tax problem does not affect exchange-traded funds. Most ETFs are index based and have almost no portfolio turnover. Also, when you buy ETF shares, those shares are created just for you and dismantled just for you when you sell the shares. Any applicable taxes are based solely on the price difference between the time exchange-traded fund shares are bought and sold.
Those are the seven main reasons why investors should choose exchange-traded funds over mutual funds most of the time. If ETFs are so much better than mutual funds, why are investors seven times more likely to put their money into mutual funds? The main reason is a knowledge gap. Most investors are not aware of all the advantages that ETFs offer. Exchange-traded funds are relatively new compared to mutual funds. Still, ETFs have been around for more than 25 years and are well established. Some investors feel that ETFs are riskier than mutual funds. Unless you invest in inverse ETFs that bet against the market or leveraged ETFs, risk exposure with ETFs is no greater than risk exposure with other investment vehicles, including mutual funds.
If you are interested in finding out more about investing in exchange-traded funds, check stockinvestor.com for additional articles on ETF investing. Future articles will provide additional information on topics like disadvantages of mutual funds, tools and rules for investing in exchange-traded funds and where to find the funds to start investing in ETFs.
Doug Fabian is the editor of three publications: Successful ETF Investing, ETF Trader’s Edge, and Fabian’s Weekly ETF Report. Doug was previously known as one of America’s top mutual fund advisors, but in recent years he has made a revolutionary 100% shift to exchange traded funds (ETFs). He regularly appears at seminars around the country.