Exchange-traded funds, or ETFs, are quite popular among American investors. An estimated 16.1 million Americans–about 12% of U.S. households–held $6.5 trillion in ETFs at the end of 2022, according to data from the Investment Company Institute. That’s a whopping 9,748% increase from 2000, when ETF ownership stood at $66 billion.
ETFs function like mutual funds in that they typically own a diversified pool of investments. Among the American households that owned ETFs in 2022, 82% also owned mutual funds, ICI data shows.
Also, because of their similarities, the differences between exchange-traded funds and mutual funds have become a bit murky among investors. Take the mutual fund version of the Fidelity Total Bond Fund (ticker: FTBFX) and the Fidelity Total Bond Fund ETF (FBND), for example. Based on literature from Fidelity, both investment selections can own “at least 80% of assets in debt securities of all types and repurchase agreements for those securities.”
Still, there are plenty of differences, and investors should give these due consideration before adding either type of investment to their portfolios.
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Exchange-traded funds can be purchased and sold like individual stocks during open-market periods and can experience price changes during the trading day. Because ETFs trade like stocks, there are generally no investment minimum requirements; investors can buy and sell one or multiple shares at the market price throughout the day.
Mutual fund trades, on the other hand, often do require minimum dollar investments and can only be executed once daily.
There are also some practical benefits to holding each in your portfolio. Here are three portfolio implications to consider:
— Trading consequences
— Thematic options
— Taxes
Trading Consequences
For investors who want to actively trade in the market during the day, ETFs do have an edge over mutual funds. Some ETFs are thinly traded in the market, however, which means that the bid-ask spreads for these ETFs could be wide and generate higher trading costs for investors. Mutual funds can be purchased or sold without any bid-ask spread, which can mean lower costs for investors.
Thematic Options
Some investors who want to invest thematically
– say in blockchain technology, cloud computing or autonomous vehicles – can do so among the nearly 8,800 available ETFs across the globe, 2,800 of which are domiciled in the U.S.
Mutual funds are generally less niche-oriented than ETFs and often track a wider index or benchmark category, like large U.S. companies, or the S&P 500.
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Taxes
Both ETFs and index mutual funds are fairly tax efficient. Capital gains, losses and dividend income related to exchange-traded funds and mutual funds are treated equally under current tax law.
One potential advantage for investors who hold ETFs in their taxable accounts is that ETFs generally experience fewer taxable events than actively managed mutual funds.
“When we see clients looking to ETFs’ tax advantages, it’s most commonly within the traditional core equity portions of their portfolios,” says Adam Hetts, a chartered financial analyst and global head of portfolio construction and strategy at Janus Henderson Investors. “In these asset classes, there are a plethora of ETF options that offer tax advantages regarding capital gains alongside significant liquidity and relatively low fees.”
An actively managed mutual fund management team may decide to sell certain technology companies, for example, if they estimate valuations have peaked at a given time. Any capital gains from those trades would be passed along to investors who own that particular mutual fund.
In fairness, though, many mutual fund managers attempt to mitigate the tax bite by incorporating carry-over capital losses and tax-loss harvesting in their overarching investment strategies.
“Many investors are well served by locating relatively tax-inefficient investments like taxable bond mutual funds and ETFs first in traditional IRAs, then Roth IRAs, and finally in taxable accounts,” says Sophoan Prak, a certified financial planner and financial advisor at Vanguard. “For the majority of investors, this approach is likely to maximize the after-tax return of their investments.”
Mutual funds and exchange-traded funds can offer multiple benefits to investors. The most effective way for investors to experience many of those benefits is to align their portfolio investments with key planning objectives and desired outcomes.
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ETF or Mutual Fund: How to Choose originally appeared on usnews.com
