ETFs V. Mutual Funds: Which is Right for You?

ETFs Vs. Mutual Funds

A basic guide to Exchange Traded Funds.

An ETF is simply a basket of individual securities which trades on the exchanges just like a stock. Generally, ETFs are constructed to track the performance of a specific index, such as the S&P 500 Index or the Russell 2000, which tracks the stocks of smaller American companies. Other ETFs are available which track the markets of specific industries, regions, or individual countries.

Advantages over stocks

–Instant diversification. An individual investor can stake out a position in hundreds and even thousands of individual companies with one trade. Risks from exposure to individual companies and securities can be instantly diversified away; the investor simply accepts the market or country or industry risk of the ETF. It may take tens of thousands of dollars or more to build a similarly diversified position holding stocks directly, but ETFs enable individual investors to attain diversification with modest amounts of money.

–Simplicity. An investor can manage a diverse portfolio of thousands of stocks and potentially dozens of countries and currencies with just a few trades.

Advantages over mutual funds

–Liquidity. While mutual funds may only be bought and sold at closing prices (generally set daily at 4pm ET for American mutual funds), exchange traded funds may be bought and sold at any time. This is an important advantage over mutual funds. For example, if an ETF investor gets news early in the day that may negatively affect financial markets, he or she may sell relatively quickly. A mutual fund shareholder would be forced to take the entire day’s losses in his or her mutual fund before selling. Conversely, ETF investors may buy faster than mutual fund investors, as well, since a mutual fund investor must wait until the end of the day before his purchase becomes effective.

–Costs. ETFs don’t have a managers and analysts on the payroll, constantly overseeing the portfolio. So where many large-cap mutual funds sport expense ratios of 0.85 percent or more, a similar ETF may be available for as little as 0.10 percent.

—Short sales. Unlike mutual fund shares, ETF shares may be sold short. In a short sale, an investor borrows shares and sells them at current market prices, planning to return the shares in the future. If the share prices go down, the investor profits, since he returns the cheaper shares to the lender.

—Limit orders. ETF investors may place a limit order, or “stop-loss” order on ETF shares, which automatically generates a “sell” order if the ETF share price drops below a specified level. This technique affords ETF investors who choose to implement it a degree of protection from major market declines.

—Low cash drag. Mutual funds must keep a supply of cash on hand to meet anticipated redemptions. Managers also often have difficulty investing large cash inflows, and so often keep large cash stakes in the fund. But since cash offers a very low rate of return, too much cash can put a drag on portfolio performance in rising markets, a situation called “cash drag.” Since ETFs are bought and sold over the exchanges, there’s no cash flow for a fund manager to worry about. ETFs therefore have a slight advantage over mutual fund shares – and even index fund shares – in rising markets, thanks to low cash drag.

—Tax efficiency. Since ETF portfolios change only to reflect changes in an underlying index, it is rare for an ETF investor to get stuck with an unanticipated capital gains distribution, which is taxable. While some mutual funds are specifically managed to keep turnover low, ETFs have one advantage which mutual funds don’t: An ETF can distribute actual securities out to redeeming shareholders, rather than sell the stock outright. This saves investors in the ETF itself from having to sell and realize taxable gains. This advantage also applies when stocks are removed from the underlying index: Rather than sell the stocks outright and forcing new investors to pay tax on gains accumulated years before they may have even owned shares in the fund, an ETF can distribute the shares themselves and limit capital gains taxes.

—Sales loads. An ETF generally does not charge a sales load, although brokerage commissions will generally apply.

Disadvantages of ETFs

–Brokerage costs. It costs money every time you buy and sell an ETF. While these charges are generally not high, paying a flat fee to a brokerage every time you make a transaction can add up – especially for investors who regularly invest small amounts into the fund, a technique called “dollar-cost averaging.” If this is you, or if you are an “active trader,” consider a no-load mutual fund instead. Expense ratios may be higher, but it costs nothing to trade in and out of them, other than taxes on capital gains.

—Market price. An ETF does not necessarily trade at the same value its underlying stocks would sell for on the open market. Occasionally, the ETF will actually trade slightly higher or lower than its market price. This variance is far less pronounced, though, than it is for closed-end funds, because ETF investors may exchange their ETF shares for the securities themselves. While this option is usually open only for larger investors (in blocks of 50,000 shares or more), it does help to keep ETF prices in line with underlying asset values.

–Dividend reinvestment plans. Most mutual funds allow investors to have dividends automatically reinvested in the fund. ETFs generally do not allow this directly, since it would require too much active management. Some brokerages do allow investors to use dividends to offset no-cost purchases back into the ETF, though. Check with your financial services provider.

–Offsets. Index mutual funds can lend out securities on margin, in exchange for payments which may help to offset the expenses of the funds. A mutual fund can also invest in index futures, if the manager believes it would be advantageous to the fund shareholders. ETFs do not lend out securities, nor do they generally buy futures.

–Odd lots. While investors generally buy mutual fund shares in dollar increments, and may therefore own fractions of shares, ETFs are sold in whole shares. “Odd lot” purchases of fewer than 100 shares may be more expensive to trade.

How to select them

The most important thing to consider when selecting an ETF is your own personal financial situation, including your time horizon and tolerance for risk. Many popular ETFs, such as the “cubes” (QQQ), are highly concentrated in specific industries, or in individual countries which may carry a good deal of currency risk and political risk, in addition to market risks. ETFs are no less risky than mutual funds – it depends on what the underlying securities are. Investors should have a reason for seeking exposure to any market or sector covered by an ETF. Ideally, that reason should be something besides “because it’s been doing well, lately.”

Using ETFs to manage taxes

Under current tax laws, investors may use capital losses to offset an unlimited amount of capital gains, and up to $3,000 of income per year ($1,500 for married couples filing separately.) That means that if you hold a fund or ETF that lost $3,000 since you bought it, you can sell that ETF and use that to offset capital gains on another investment you sold, or to offset $1,000 of income. Which means you don’t have to pay taxes on that income. Further, if you don’t have enough income or capital gains against which to match the loss, you may carry the loss forward, to apply it in future years. The catch: You cannot buy back that security you sold for a loss, or a substantially identical one, for at least thirty days – a violation of IRS “wash sale” rules.

To beat the wash sale rules, consider purchasing an ETF that covers the same industry market as the security or fund you sold. For instance, you could sell shares in a large cap stock fund, take a capital loss deduction, and then use the proceeds to purchase a SPIDER, which is an ETF that tracks the S&P 500 index of large cap stocks.