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Are ETFs better than mutual funds?

By November 16, 2020 No Comments

Are ETFs better than mutual funds? We think so, and here are three reasons why:

  • ETFs are more transparent than mutual funds
  • ETFs offer greater flexibility
  • ETFs have better tax efficiency

We’ll address each point in more detail in this article and clearly outline why ETFs are better than mutual funds.

ETFs have better transparency

ETFs are more transparent than mutual funds. This transparency is evident in two primary ways:

  1. In the way ETF holdings are disclosed versus mutual fund holdings
  2. In the way ETFs are priced versus mutual fund pricing

The vast majority of ETFs disclose their holdings each and every day. This means that you can typically always look up what securities are held inside an ETF. The same cannot be said for mutual funds. Mutual funds are only required to disclose their holdings quarterly. While mutual funds can choose to disclose their holdings daily, the majority do not. As a result, it’s much easier to know what’s inside of an ETF than it is a mutual fund.

Not only is it easier to know what’s inside of an ETF, it’s also easier to know the price it is trading at. This a key difference: ETFs trade on exchanges throughout the trading day. So if you want to know how an ETF is performing you can just type in the ETF symbol and voilà! Mutual funds do not trade on exchanges throughout the day so there isn’t a clear way to know how a mutual fund is performing until after the market closes.

ETFs offer better flexibility than mutual funds

What’s more, if you want to buy or sell an ETF in the middle of the day, you can do so at the current market price. If you want to do the same thing with a mutual fund, you’re restricted. Trades in mutual funds only execute at the closing price. This is a huge mark against using mutual funds in our view.

Just this last week, on Monday November 15, the S&P 500 opened higher by 4%, only to move lower the rest of the day. If you owned an S&P 500 ETF like VOO and wanted to sell, you had the option of locking in that 4% gain right at the open. The same attempt to sell a comparable mutual fund would have executed at the close, and by then the S&P 500’s gain was only 1.50%. This real life example cost mutual fund investors 2.50% compared to ETF investors!

Lastly on this topic, isn’t it nice to know how your account is doing on a given day? When you own ETFs you always know exactly how your investments are performing. So if the market is up big or down big and you’re curious how your portfolio is handling the swings, you can just log into your account and check. If you own mutual funds, you won’t know the answer until after the market closes each day. That’s annoying and it’s one of the main reasons we think ETFs are better than mutual funds.

Mutual Funds leave you with taxes

We saved the best reason for last. ETFs are far more tax efficient than mutual funds. Investors can buy and hold ETFs and defer any capital gains tax until the ETF is sold. Investors who buy and hold mutual funds may pay capital gains taxes even if they do not sell the mutual fund. That’s a raw deal for buy and hold investors. Consider the following two examples:

  1. Person A needs cash for a down payment on a house. So he decides to sell $60,000 worth of XYZ mutual fund which he’s owned for a number of years. In order to meet Person A’s redemption request, XYZ mutual funds sells $60,000 worth of holdings inside of the fund. If there are any capital gains from XYZ’s sale, those gains are distributed to all shareholders of the fund. So Person B, who also owns XYZ mutual fund but did not sell it and doesn’t need cash, is still going to be on the hook for paying capital gains tax as a result of Person A’s redemption.
  2. ABC mutual fund has decided to sell a stock inside of its fund that has risen 50% from when it was purchased. ABC mutual fund is required by law to redistribute all capital gains to its shareholders. Therefore, even if ABC mutual fund shareholders did not sell shares in the mutual fund they will still share in the tax liability created when ABC mutual fund sold the individual stock for a 50% gain.

In both of these examples, someone who has nothing to do with the transaction in question is still liable for taxes simply because they own the mutual fund. ETFs don’t work like that.

How do ETFs get taxed?

When you buy or sell an ETF you are transacting on the secondary market. Said another way, your transaction is taking place on a market exchange, like the Nasdaq, and is being matched with another investor. So if you want to sell 100 shares of an ETF you own, you can usually find another investor who wants to buy them (in a millisecond). Therefore, the securities inside of the ETF do not actually need to be sold just because you want to pull your cash from the fund. Unlike with mutual funds, one investor’s decision in an ETF is not going to have ramifications for all shareholders of that ETF.

What about in the rare case that there isn’t a market for you to sell your ETF shares in (think March 2020 liquidity crunch)? Well, admittedly, this answer is more complicated. However, the important thing is that it is done without creating any tax liability for shareholders of the ETF (unlike with mutual funds). Here’s the high level answer, courtesy of GlobalX:

This more complex answer also applies to the question of how an ETF can sell a stock inside of the fund at a gain without passing the tax liability onto shareholders. Again, from GlobalX:

ETFs are better than mutual funds

All of this information adds up to something we think is indisputable: ETFs are better than mutual funds. ETFs offer better transparency, both for knowing what you own and easily tracking how your investment is performing. In addition, because ETFs trade during the day you have better flexibility for buying and selling them, unlike mutual funds which only trade once per day after the market closes. Lastly, but most importantly, ETFs are more tax efficient than mutual funds.

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