Should I Use Mutual Funds or ETFs?
Exchange-traded funds (ETFs) and mutual funds are both popular investment vehicles that can help investors who don’t want to pick individual stocks or bonds themselves. Both mutual funds and ETFs are essentially a basket of securities (i.e. stocks, bonds, etc.). If you own shares of a mutual fund or ETF, you own shares of the basket instead of the individual companies inside the basket. This allows regular, everyday investors to more easily and effectively diversify their portfolio.
So which is right for you? Here at Redeem Wealth, we generally believe ETFs are preferable to mutual funds. In most cases, you can get all the benefits of a mutual fund and more with ETFs. Especially for taxable brokerage accounts, ETFs are often much more attractive. There are 3 reasons for this:
Tax Loss Harvesting: ETFs are traded on stock exchanges, just like individual stocks. This means that investors can buy and sell ETFs throughout the day at market prices. In contrast, mutual funds are bought and sold only once per day (at the end of the trading day) based on their net asset value (NAV). There are some stocks that may move 3%, 5%, or possibly even more in a single day! With mutual funds, you may not be able to capture those quick swings in price because they only trade at the end of the day. The best tax loss harvesting opportunity isn’t always the closing price!
Capital Gains Distributions: Mutual funds are required to distribute capital gains to investors at the end of the year, which can result in a high tax bill for investors. Remember, it’s not the fund manager who pays the taxes on all the trades he placed in the fund, it’s the investor who is responsible for those taxes! ETFs, on the other hand, tend to have low turnover, which many times results in less capital gains and a lower tax bill.
Contributions and Redemptions: ETFs are more flexible than mutual funds in how they account for investors’ redemptions and contributions. This additional flexibility, if taken advantage of, creates the potential for additional return through more tax-efficient management. This is why it’s critical to use the best fund managers. For this reason, we love Dimensional Fund Advisors (DFA)! DFA takes advantage of ETF flexibility to keep the tax impact of trading as low as possible.
There are usually no blanket statements when it comes to personal finance and investing. In the case of mutual funds and ETFs, that is also true. If you need help understanding more about what makes the most sense for you, speak with a trusted advisor who can assist in educating you the pros and cons of different mutual funds and ETFs.