By Hannah Szarszewski, CFP
Mutual funds and ETFs have a lot of similarities and they provide a great way to achieve diversification in your portfolio. I’m often asked which is better or which should be used if you’re managing your own investments. The short answer is that it depends.
While there is a lot of information on the differences between mutual funds and ETFs, there is much less information on why it matters and how it relates to DIY investors. My goal with this article is to help you decide which may be best for your situation. First, let’s briefly compare the differences and why they matter. Then, we can discuss which may be the right choice for you.
Overall, ETFs are more tax-efficient than mutual funds. Note that this is irrelevant when investing in a retirement account such as an IRA or Roth IRA. But if you’re investing in a taxable brokerage account, the tax differences can be significant.
Turnover reflects the fund holdings that changed over the previous year. Higher turnover can equate to higher taxes if distributions are made. Most ETFs have low turnover and in general, you’ll find more mutual funds with higher turnover. Turnover will likely be the same if comparing index ETFs to index mutual funds.
Also, mutual funds are more likely to have distributions compared to ETFs. Distributions are fund earnings that are passed on to investors and they’re more common with mutual funds because of how a mutual fund operates. Distributions result in taxable income and can sometimes amount to over 5% or even 10% of your net asset value (NAV).
Tax efficiency is the most common reason that some investors prefer ETFs. While important, it shouldn’t be the only factor you consider.
How they trade
ETFs trade throughout the day like stocks. They can trade above or below their net asset value (NAV) so you could get a better or worse price than other investors depending on the time of day you trade. Mutual funds settle at the end of each day and everyone gets the same price for the day. During increased market volatility, the way mutual funds trade can be a good thing because volatility throughout the day is evened out for everyone. But this is a double-edged sword – if the market drops consistently in one day, the mutual fund price could be worse than when you trade an ETF.
Additionally, there’s a trading cost with ETFs that many investors may not recognize – the bid/ask spread. When you buy an ETF, you use the ask price and when you sell an ETF, you use the bid price. The bid price is almost always lower than the ask price. If the bid/ask spread is wide, the trading cost is higher. You’ll notice wider bid/ask spreads during highly volatile markets. Or during normal markets, the fund could inherently have less trading volume which means the fund is less liquid.
Next, you can buy mutual funds with a set dollar amount. For example, you could invest $200 in a mutual fund. ETFs have share prices and you purchase a number of shares based on the share price. So, if you have $200 to invest and the share price is $150, you can purchase one share and the remaining $50 won’t be invested. This results in more of your money sitting out of the market, until you can purchase another share. Note that more and more custodians are beginning to allow fractional shares so this may be less of a hindrance going forward. At this time, purchasing fractional shares isn’t as common with ETFs as with individual stocks but this could change. Even if it does, many investors still prefer the ease of purchasing mutual funds.
Lastly, with an ETF, you can execute different types of trade orders. For example, you can use a limit order (as opposed to a market order) which enables you to set a price you’re willing to buy or sell at. Mutual funds don’t provide this type of control.
Fees and minimums
ETFs won’t have load fees or 12b-1 fees. Not all mutual funds have these types of fees but many do. This may not apply to you but it’s important to note that mutual funds can potentially be more expensive (in a number of ways, as discussed below).
If you have more invested in a mutual fund, your investment expense ratio may be less because you could be eligible for a less expensive share class. This seems like a good thing, except when you don’t have enough to be in the desired share class for every fund. ETFs don’t have different share classes – all shares are the same price for everyone.
Also, with some custodians, there could be transaction fees for trading mutual funds and ETFs. If there are, mutual fund transaction fees will most likely be higher.
Lastly, mutual funds can have minimums. For example, you may need an initial investment minimum of $1,000 before you can purchase a fund. When this is the case, it can take a while to introduce different funds into your portfolio and to achieve your target asset allocation between subclasses. This barrier doesn’t apply to ETFs. As long as you can afford one share of an ETF (or in some cases a fraction of a share), you can purchase it.
I rarely see this discussed but it’s perhaps one of the most important factors. Mutual funds may be the best choice for you simply because of automation. With mutual funds, automatic savings contributions transferred into your account can be automatically invested according to the percentages you specify. For example, let’s say you save $100 per month. You can set up automatic investing and have 50% invested in one fund, 25% invested in a different fund, etc. (you get the idea). With nearly every custodian, this isn’t possible when purchasing ETFs because of how they trade.
This may not seem like a big deal but going into your account every single month to invest your savings can quickly become a chore. My experience is that most investors don’t remember to do it as soon as their savings contribution transfers to the account (so their savings sits out of the market for longer). Automating is a feature that shouldn’t be underestimated because it makes investing so much easier for monthly contributions! You can set it and forget it. It also takes away any temptation to try and time the market (which, based on evidence, reduces an investor’s wealth over time – but that’s another topic entirely).
Which is best?
There are other differences between mutual funds and ETFs but they aren’t as important to this discussion. While there isn’t a hands-down clear-cut winner to this popular debate, there is a best choice for you and your specific situation. Since there are many no-minimum, low-cost options for mutual funds, they may be best for you because of automation. Plus, many investors enjoy the simplicity of trading them compared to an ETF.
On the other hand, if you have a large amount in a taxable brokerage account, then the tax efficiency of ETFs could tip the scale for you. Or you may prefer ETFs because with a mutual fund you won’t know the trade price until the end of the day. Hopefully, you’re able to make a more informed decision now that you understand how the differences pertain to you. Also, consider that you can utilize both ETFs and mutual funds to your advantage. You don’t actually have to pick between the two!
About the author: Hannah Szarszewski, CFP®
Hannah Szarszewski is a CERTIFIED FINANCIAL PLANNER™ Professional and Accredited Financial Counselor® Practitioner. She is the founder of Blue Mountain Financial Planning, LLC and focuses on integrating financial coaching and education into the financial planning process. She has partnered with clients of all ages and various walks of life to help them achieve financial independence and live life to the fullest.