What they are, how they work, and why they’re better than mutual funds
What if you took the diversification of a mutual fund, but made it less expensive, more tax-efficient1, and with a much lower minimum investment? Oh, and made it easier to buy and sell?
That, in essence, is an exchange-traded fund, or ETF.
Like a mutual fund, an ETF pools investors’ money and buys a basket of stocks. And, like a mutual fund, ETFs offer investors many options: large companies, small companies, emerging markets, specific sectors, precious metals, real estate, and the list goes on.
But compared to mutual funds, ETFs often have:
- Lower fees (typically less than half of what a mutual fund charges)
- Much lower minimum purchases
- Same-day purchases and sales
- Up-to-the-minute pricing
- Greater tax efficiency, since the fund itself doesn’t sell shares to satisfy redemptions
What is an ETF?
ETFs have been around since 1993, according to the Investment Company Institute, and their popularity is soaring: over $4 trillion is invested in ETFs, $1 trillion of that in the last year alone. By comparison, approximately $17.7 trillion is currently invested in mutual funds.
ETFs are a basket of stocks that typically track an index, such as the S&P 500. Shares trade daily on major stock exchanges, and can be bought and sold like stocks.
Because they passively track an index, rather than employ active money managers, fees are much lower. Rather than having minimum purchase thresholds, as many mutual funds do, buying an ETF is as inexpensive as buying a single share, just like buying a single share of stock. Selling some or all of your ETF shares is just like selling shares of stock.
One caution: like stocks, buying an ETF can include paying a trading commission, though recent price wars have meant that many firms offer ETFs, as well as stocks, with no commissions.
About Taxes and Returns
Because they don’t have managers actively buying and selling stocks, and because they typically track an index, ETFs can be more tax-efficient than mutual funds. They don’t tend to distribute a lot of capital gains, an event that typically triggers taxes. Also, unlike a mutual fund, a fund manager doesn’t have to sell shares when an investor wants to cash out, an event that could trigger capital gains.
There’s another benefit, too. Many mutual funds strive to beat the index that closely matches their holdings. But most don’t.
- 85% of all mutual funds have underperformed the market in the last 10 years2
- 92% have underperformed the market in the last 15 years3
However, be aware that mutual funds currently offer more choices to investors4. There are roughly four times as many mutual funds (8,000 as of the end of 2018) as there are ETFs (2,000). However, because many funds are essentially identical to competitors, the actual number of choices is much less. It would be difficult to find an asset class that isn’t available in an ETF.
Mutual funds and ETFs both offer greater diversification than owning individual stocks, which is inherently less risky.
Comparing an ETF with a Mutual Fund
These common investment options highlight how ETFs and mutual funds compare.
The Vanguard 500 Index Fund Admiral tracks the S&P 500 index, a common index that tracks the performance of the largest 500 companies (by market capitalization) in the U.S. (It actually tracks 505 stocks, because five of the companies in the index have two classes of stock.)
That fund has an expense ratio of 0.04%. The minimum investment is $3,000.
Vanguard’s equivalent ETF carries an expense ratio of 0.03%. The minimum investment would be one share, approximately $255 at the time of this writing (it’s fluctuated between $200-311 during the past year).
Both track the same index. Both would be suitable for the same types of accounts. The only substantive difference is that one has a much lower minimum purchase, a slightly lower management fee, and the ability to be purchased or sold within minutes any time the stock market is open.
Why we recommend ETFs
Because of the much lower costs, ease of purchase, and tax efficiency, ETFs are hard to beat. Put simply, returns may fluctuate, but costs are constant. We believe that most investors, especially those looking for the best value, are much better served by ETFs. Our CFP® Professionals recommend ETFs as the foundation for our clients who are building a brighter financial future for themselves and their families, and Facet Wealth consistently follows that philosophy.
1, 4 Pareto, C. (2020, March 20). Mutual Fund vs. ETF: What’s the Difference? Investopedia. https://www.investopedia.com/articles/exchangetradedfunds/08/etf-mutual-fund-difference.asp
2, 3 Pisani, B. (2019, March 15). Active fund managers trail the S&P 500 for the ninth year in a row in triumph for indexing. CNBC. https://www.cnbc.com/2019/03/15/active-fund-managers-trail-the-sp-500-for-the-ninth-year-in-a-row-in-triumph-for-indexing.html