Should You Dump Your Mutual Funds For ETFs? What's the real Difference?

IBD ^ | 10/15/2019 | Paul Katzeff

[SeekAndFind]

For the diversified portion of countless investors' portfolios, the key choice has been ETFs vs. mutual funds for years now. For many investors, the choice boils down to this: Exchange traded funds tend to be cheaper than mutual funds. So shouldn't investors simply stick with ETFs? X

In fact, shouldn't you dump your mutual funds for ETFs?

You might be tempted to switch since many financial advisors and independent investment strategists now focus on using ETFs rather than mutual funds to build clients' portfolios. That's mainly because of cost, flexibility, transparency and tax efficiency:

ETFs cost less. Most ETFs have lower expense ratios than actively managed mutual funds. Expense ratio is the term used to show what percentage of your assets you pay annually to own a fund. The average stock ETF carries an expense ratio of 0.38% vs. 1.08% for the average stock mutual fund. For a portfolio of $100,000, that would be a difference of $700 a year. Be aware, though, that many index mutual funds now also offer low expenses ratios. And keep in mind that ETF expenses aren't confined to expense ratios. There's also bid-ask spread, which can be wide for lightly traded ETFs.

ETFs have more flexibility.ETFs can be bought and sold throughout the day, so investors can act quickly to take advantage of opportunities that arise or take their portfolio out of harm's way if the market takes a sudden bad turn. Orders to buy or sell mutual funds are executed only once a day at after the close of market trading. That's when their net assets values are calculated based on their holdings.

And, like mutual funds, you can place limit orders on ETFs.

[SeekAndFind]

What do most mutual funds have that most ETFs don’t? Active management. Portfolio managers run most mutual funds, buying and selling stocks and bonds with the aim of maximizing gains and minimizing losses.

The problem is that most active managers often don’t outperform their benchmark index in the long run. That raises the question of why pay more for a mutual fund if it doesn’t beat its benchmark index that’s a lot cheaper to own?

That might help explain why five of the 10 biggest U.S. diversified stock funds tracked by Morningstar Direct are index funds, led by Vanguard Total Stock Market Index (VTSMX) with $827 billion in assets, including all shares classes.

[reed13k]

In addition a lot of ETFs also have dividends and options. So I can buy an ETF and sell a out of the money call on it to generate additional income while holding on to it with at least the dividend to offset any downside. Every % counts.

[pepsionice]

On VTSMX (since it got mentioned)....it’s worth talking about the past decade, with a upward trend-line, and currently sells at 73.21 (would have been around 20.00 in 2009. However, the entire decade prior to that...it was mostly flat. The dividend pays near 1.70 a share. I would regard it as a ‘safe’ stock for long-term investment (more than a decade), but if you wanted a maximum safe index fund, you could probably do better. A year ago, it would have gone for 70.00, and it’s seen at least seven drops but each time (give it a month or so), it has returned, and improved.

[Chewbarkah]

One of my concerns with mutual funds is performance in a down market, particularly a sudden selloff. Panicked investors redeem their mutual fund shares, forcing the fund to sell off just at the moment that prices have dropped irrationally. That leads more customers to redeem, perpetuating the rout.

ETFs face somewhat the same problem, but my guess is that the ability to sell during the day spreads the damage and makes investors less likely to liquidate everything.

Is there any research on performance of mutual funds in sharply down markets versus the markets themselves? (Broad index funds likely don’t have much difference, but focused funds might).

My bias is towards holding individual securities so your fate isn’t tied to someone else’s choices.

[gattaca]

bmp

[poinq]

Never buy mutual funds. The big reason is that you pay taxes every year on them. ETFs grow tax free. Its like an IRA with no rules. You just buy SPY and forget it. Your money grows tax free with extremely low fees and you don’t pay taxes until you sell them.

With Mutual funds you have higher fees and then you have to deal with a 1099 every year. Then you have to figure out your cost basis. What a pain. Plus the fact that you have a day delay before you can get out. Oh, and if you look at a bunch of mutual funds (not all), they have ETFs inside them. So they are just hiding their ETF inside a mutual fund and still charging you the ETF fees and the mutual fund fees.

[grania]

What mutual funds have is fees. Doing ones own trading is getting close to no charge at all.

[proxy_user]

It would be interesting to see if the Authorized Partners arb the ETFs to the NAV during a liquidity crisis. I don’t believe they’re obliged to do so.

[1Old Pro]

It won’t matter which you own, funds or etf’s if Trump is not re-elected. Everything will crash, except perhaps gold.

[Sequoyah101]

Ping and:

From what I have seen in a non rigorous analysis but merely observation, what ETFs lack in management “advantage” is easily made up for in fees paid to mutual fund management. Ditto for financial managers. That is considering sane portfolio management as a long term investment and not a trading account.

Wall Street and money management are mostly just a scam to skim 1% of assets or more off the top of your hard earned savings each year.

[Larry Lucido]

Let's ask an ET farmer.

[Chaguito]

A diverse portfolio of closed end funds has provided us a very substantial retirement income in dividends over the last four years, while keeping up with the S&P before withdrawals. There is a lot of scary-sounding propaganda against CEFs out there, none of which I find to be true. Very similar to picking dividend stocks, but with twice the dividend.

[Pajamajan]

Bookmark.

[Dave Wright]

I moved out of mutual funds to index ETFs over time after researching their advantages. The biggest advantage is that if the market goes down significantly both mutual funds and ETFs would likely have to sell assets to cover redemptions. With mutual funds this would result in huge capital gains taxes on the stocks sold which would be passed on to the fund holders that year. So not only does your investment go down but you get hit with a big capital gains bill to boot. With ETFs they can raise assets by selling stocks without affecting the number of ETF shares thus avoiding a big tax bill for the ETF holders.

[entropy12]

Timing made me more profits than worrying about which fund or ETF to trade. As a long term trader, I buy sectors which are selling at discount. For example when oil was under $30/barrel, it was time to load up on energy sector mutual funds/ETF’s. When the whole market is 25-30% below previous high’e, it is time to load on S&P index funds. Again, this strategy is for long term traders (3-5 years).

[entropy12]

Very good point!

But then one of my successful stock trader used to say, “he wishes his tax bill was over a million $$, because that would mean he made $3 million in profits”.

[Lou L]

ETFs grow tax free. Its like an IRA with no rules. You just buy SPY and forget it.

What about ETFs that pay dividends? You have to claim those dividends as income, and then you have to pay taxes on them.

[Sequoyah101]

More good points in favor of the ETF. I am not one who subscribes to the advice of not caring about taxes so long as you make a profit. Making gains on profits you don’t pay taxes on makes a lot of sense to me especially if the gains are LT cap gains or can be deferred by changing the basis to zero upon death.

[Disambiguator]

What mutual funds have is fees. Doing ones own trading is getting close to no charge at all.

Schwab is now offering zero-commission trades.