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As more Americans take a hands-on approach to their finances, many are weighing whether to invest in exchange-traded funds (ETFs) or mutual funds.
Both offer a simple way to build a diversified portfolio of stocks or bonds, and at their core, the two investment vehicles are very similar. But key differences – including how they trade and how they are taxed – can shape long-term returns, experts say.
“When investors compare ETFs and mutual funds, it’s important to start with what they have in common: both are professionally managed portfolios that provide diversified exposure to stocks or bonds,” Kathy Kellert, head of index equity product at Vanguard, told FOX Business. “The biggest differences for investors come down to how the funds are bought and sold and how taxes are handled.”
ETFs can trade at slight premiums or discounts to the value of their underlying holdings. (Spencer Platt/Getty Images)
WHAT ARE ACTIVE ETFS AND HOW ARE THEY RESHAPING HOW AMERICANS INVEST?
While ETFs trade throughout the day on exchanges – like stocks – with prices that fluctuate in real time, mutual funds are priced once daily after the market closes.
“An ETF is best thought of as a mutual fund that trades on an exchange like shares of stock,” Dan Sotiroff, associate director of U.S. passive strategies research at Morningstar, told FOX Business.
Because of that structure, ETFs can trade at slight premiums or discounts to the value of their underlying holdings, though Sotiroff noted the gap is typically “very small and inconsequential.”
Taxes are another major consideration.
ETFs use a structure that allows many transactions, like rebalancing, to take place without triggering taxable capital gains. Mutual funds, on the other hand, may distribute those gains to investors in the year they are realized, according to Kellert and Sotiroff.
A BEGINNER-FRIENDLY ETF PORTFOLIO THAT REQUIRES ALMOST NO MAINTENANCE AND DELIVERS LONG-TERM RESULTS
ETFs trade throughout the day on exchanges while mutual funds are priced once daily after the market closes. (Lilli Förter/picture alliance via Getty Images)
“All things equal, ETFs are more tax efficient than mutual funds,” Sotiroff said. “ETF investors will still have to pay capital gains taxes when they sell their shares, so ETF investors are really deferring capital gains, not avoiding them. The advantage is that ETF investors can choose when to realize those gains while mutual fund investors have less control.”
Will Rhind, CEO of GraniteShares, described ETFs as a “new technology” compared to the “old technology” of mutual funds.
“ETFs are, generally speaking, cheaper, more tax efficient, provide much broader choice and are, of course, liquid,” Rhind told FOX Business.
Unlike many mutual funds, which may require minimum investments of $1,000 or more, ETFs can often be purchased for the price of a single share or even a fraction of one, according to Rhind.
COULD S&P 500 ETFS ALONE FUND YOUR ENTIRE RETIREMENT?
Taxes are another major consideration when choosing between ETFs and mutual funds. (iStock)
However, experts say that choosing between ETFs and mutual funds ultimately depends on the investor.
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“For many investors, the tax efficiency, intraday trading and transparency of ETFs… make them a compelling choice. For others – particularly for retirement accounts, where the tax efficiency is not an impact – [mutual funds] allow dollar investing versus share prices and are a long-standing choice,” Riz Hussain, senior investment portfolio strategist at Schwab Asset Management, told FOX Business.
Kellert added, “What matters most is not the wrapper, but whether the fund aligns with an investor’s goals, time horizon and comfort level. When used thoughtfully, both ETFs and mutual funds can play an important role in a well-diversified portfolio.”