ETFs May Be Better Than Mutual Funds, But …
Among the questions I’ve been asked many times over the years is whether it is better to own mutual funds or exchange-traded funds (ETFs). My response to each person who has asked it has consistently been to stick with the vehicle they find easier to use.
A study published in the September issue of the Journal of Banking & Finance sought to answer the same question. Rather than looking at mutual funds and ETFs overall, the authors focused on passive funds. Doing so provided more of an apples-to-apples comparison. Their conclusion? ETFs realize higher returns in aggregate.
Before dumping all of your mutual funds and switching to ETFs, look beyond the above summarization. The performance advantage of ETFs is very small: 1.615 basis points per month. Since 100 basis points equates to a single percentage point, the differential in returns is 0.01615% per month. This pales in comparison to the impact that your portfolio management decisions—allocation, when to buy and sell, etc.—have on your realized returns. Still, there are factors to consider when making the choice between a mutual fund and similar ETF.
For taxable accounts, there is an argument to be made for favoring ETFs. This is particularly the case if your income puts you into the 20% capital gains tax bracket and/or trust taxes are an issue. Taxes vary by fund category, with bond funds and foreign stock funds incurring more capital gains. Overall, the average passive mutual fund distributed 2.5% in capital gains versus 0.2% for the average ETF.
For tax-preferred accounts—traditional IRAs, Roth IRAs, etc.—capital gains distributions are not taxed and therefore are not a direct consideration. (They could be a sign to look at the level of portfolio turnover and a fund’s expense ratio.)
Transaction costs are an issue for ETFs. Because they trade like stocks, trading costs can reduce their return advantage. ETFs may also trade above or below their net asset value. Mutual funds, in contrast, are bought and sold at their net asset value at the end of a trading day. Mutual funds can also be purchased in fractional amounts. This is advantageous to those who are making regular contributions; especially those with smaller balances. ETFs must be purchased in whole share amounts.
It’s easy to overthink the choice. Rather than getting bogged down, put thought into what types of indexes you want exposure to (e.g., large-cap stocks, intermediate-term corporate bonds, etc.). Even seemingly small differences in how much you allocate to equities versus fixed income can influence your returns by 100 basis points (1%) or more—a far greater impact than making the choice between an ETF and a similar mutual fund.
Note: This article appeared at EconMatters.com, courtesy of Charles Rotblut, CFA is the VP and Editor for American Association of Individual Investors (AAII). Charles is also the author of Better Good than Lucky.
The views and opinions expressed herein are the author’s own, and do not necessarily reflect those of EconMatters.
Category: ETFs, Mutual Funds
