I frequently encounter is the debate surrounding ETF vs mutual fund. Specifically, investors are curious about which option is more cost-effective and delivers better long-term performance. In this article, we’ll break down the key differences between ETFs and mutual fund indexes, including their costs, potential returns, and factors to consider when investing.
ETFs vs. Mutual Funds...the Basics
First, let’s briefly define ETFs and mutual fund indexes. An ETF, or exchange-traded fund, is a collection of securities that can be traded on an exchange, similar to stocks. Mutual fund indexes, on the other hand, are investment vehicles that pool investors’ money to buy a diverse range of assets, tracking specific indexes. Both options offer investors an easy way to diversify their portfolios.
In the ETF vs mutual fund debate, cost is a crucial factor. The expense ratio, the annual fee charged by the fund manager, is a primary consideration. According to a study by the Investment Company Institute, the average expense ratio for index ETFs was 0.18% in 2020, while the average expense ratio for index mutual funds was 0.57% [1]. This difference in fees can have a significant impact on long-term performance, as lower fees allow investors to keep more of their returns.
Another important aspect to consider is tax efficiency. Generally, ETFs are more tax-efficient than mutual fund indexes due to their unique structure. As highlighted in Vanguard’s research paper, ETFs are structured in a way that allows them to avoid triggering capital gains taxes when buying and selling securities within the fund [2]. This tax efficiency can lead to higher after-tax returns for investors.
ETFs vs. Mutual Fund Costs
Comparing long-term performance in the ETF vs mutual fund debate, it’s essential to weigh the impact of fees and taxes on returns. A study by Morningstar found that low-cost funds outperformed high-cost funds across various asset classes and time periods [3]. This finding suggests that the lower fees and greater tax efficiency of ETFs may provide an advantage in terms of long-term performance compared to mutual fund indexes.
However, there are potential drawbacks to investing in ETFs. For example, ETFs are traded on an exchange, which means that investors may incur brokerage fees and bid-ask spreads when buying and selling shares. These additional costs can offset some of the advantages associated with lower expense ratios. Moreover, some niche ETFs may have low trading volumes, resulting in wider bid-ask spreads and increased trading costs.
Operations
On the flip side, mutual fund indexes offer certain benefits, such as automatic investment and reinvestment options, which can simplify the investing process for some individuals. Furthermore, mutual fund indexes are bought and sold at the net asset value (NAV) calculated at the end of the trading day, eliminating the need to worry about bid-ask spreads and other trading costs.
The choice between ETFs and mutual fund indexes depends on the individual investor’s preferences, goals, and investment strategies. When it comes to cost and long-term performance, ETFs may have an edge due to their lower expense ratios and greater tax efficiency. However, investors should carefully consider the potential drawbacks of ETFs, such as trading costs and bid-ask spreads, before making a decision.
Understanding the key differences in the ETF vs mutual fund debate is crucial for making informed investment decisions. By weighing the costs, long-term performance, and tax efficiency of each option, investors can choose the best investment vehicle to meet their financial goals. As always, I encourage investors to consult with their financial advisors before making any decisions about their portfolio.
Adam Faust, Founder and Chief Investment Officer
Deep Blue Financial LLC, Northbrook IL
References:
[1] Investment Company Institute. (2021). “Trends in the Expenses and Fees of Funds, 2020.” Retrieved from: https://www.ici.org/pdf/per24-10.pdf
[2] Vanguard. (2021). “Understanding ETFs: The ins and outs of tax efficiency.” Retrieved from: https://www.vanguard.com/pdf/ISGETF.pdf
[3] Morningstar. (2019). “How Expense Ratios and Star Ratings Predict Success.” Retrieved from: https://www.morningstar.com/content/dam/marketing/shared/research/foundational/ultimateguidetoratings/705796-HowExpenseRatiosAndStarRatingsPredictSuccess.pdf