Mutual funds have long been the go-to investment for many investors, thanks to their one-stop-shopping nature. In general, mutual funds are actively managed by professionals who do the investment picking for you and, in theory, choose a variety of investments to help reduce risk while attempting to outperform their benchmark. This comes at a price, of course, and sometimes a hefty one. Exchange-traded funds (ETFs) are designed to closely track companies in a particular index. The index can be comprised of any basket of companies, including those in a particular sector, associated with a specific style, companies of other countries and global regions, etc. They have gained tremendous popularity, with over 1100 ETFs and ETNs (Exchanged Traded Note, which is similar to ETFs but includes bond characteristics) as of this posting. In fact, ETFs have become the investment of choice for many professional money managers and are becoming more common in company retirement plans.
A few key characteristics of ETFs: Taxes
ETFs are generally considered more tax-efficient than mutual funds because most are passively managed. As mentioned, this means that they are designed to closely track companies in a particular index. Because ETFs trade directly on an exchange (similar to stocks) owners of ETFs don’t have to pay capital gains at the fund level, which is not the case with mutual funds. If you held a mutual fund in 2007 and 2008, you may have had to pay capital gains on the fund, while having suffered a decline in your Net Asset Value! This was a real double whammy for investors who had substantial mutual fund holdings.
Cost
Given ETFs primarily track an index (passively managed), they don’t tend to trade as frequently as mutual funds. Because of this feature, many have lower operating costs, and as such, lower fees compared to mutual funds.
Performance
While most mutual funds aim to outperform their respective benchmark and may succeed from year to year, they don’t always succeed over the long term. So, in some cases, investors end up paying higher fees for average performance. Most ETFs are index funds, so by design, don’t claim to outperform an index.
We believe that ETF universe will continue to expand, and perhaps one day, even supplant the word of mutual funds. More and more actively managed ETFs are springing up. These typically come with a higher price tag than their passively managed cousins. But the fact they can be traded directly on an exchange means that they offer similar tax characteristics as the index variety – not an inconsequential consideration for most investors.
Alexis Advisors LLC is a registered investment advisor with the Commonwealth of Virginia. Information and concepts contained herein is for informational purposes only and should not be considered investment advice, nor is it intended as an offer or solicitation with respect to the purchase or sale of any security. Advice may only be provided after entering into an advisory agreement with the Advisor. Information is at a period in time and subject to change. Please see our Disclosures document for further disclosures and definitions contained in this article.