Why ETFs Can Be Better Than Mutual Funds

Nowadays, ETFs are all the rage in the investing world. But what are ETFs and why are people increasingly replacing their mutual funds with them? To understand them better, let's begin with a brief overview of the basics.

Quick introduction to Mutual Funds & ETFs

Mutual funds and ETFs (Exchange-Traded Funds) offer easy and diversified investment options.

Mutual funds act as a one-stop shop, allowing you to buy or sell a bundle of investments directly through them. Buying and selling occurs once per day at 4 PM EST, which helps fund managers efficiently manage inflows and outflows of investor money.

ETFs, on the other hand, sell a bundle of assets to the public and don't handle transactions after the initial sale. From then on, investors trade these bundles directly with one another just like they would with an individual stock or bond, with the price based on the performance of the underlying assets. This makes ETF management less cost intensive for the manager on a daily basis compared to mutual funds, although ETFs can create more asset bundles if demand increases.

Both mutual funds and ETFs can track the same index or strategy. In tax-advantaged accounts, such as IRAs, the biggest differences in holding mutual funds versus ETFs is the ability to trade at any time with ETFs and the ability to buy or sell whatever dollar amount you desire with mutual funds. However, when investing in taxable accounts, the differences between the two can affect your returns and taxes!

A note on taxes

According to IRS Regulation M, mutual funds and ETFs are not required to pay taxes on their gains. Instead, these gains must be distributed to the fundholders, who then become responsible for paying the taxes. This approach helps avoid double taxation, ensuring that the actual owners of the investments—like you and me—are the ones who pay the taxes.

Structure affects performance

As we learned in the previous sections, ETFs operate somewhat like a closed loop. They buy and sell securities to match their index or strategy without involving investors in day-to-day operations. When someone wants to buy an ETF, they purchase it from an existing owner just as they would a stock or bond. In contrast, mutual funds do not allow you to transfer ownership when you are done holding the investment.

When you want to buy or sell a mutual fund, you do so directly with the fund itself. As a result, increased trading activity by fund holders can lead to an increase in the number of taxable events that the mutual fund must then pass on to the remaining fund holders since they may have to sell holdings that have appreciated. With ETFs, sales of the underlying investments only need to occur when the index or strategy changes, not when fund holders decide to liquidate their holders.

Therefore, during periods of high market volatility, investors are historically more likely to request their money back due to fears of what may happen next to market prices. When this happens, a mutual fund must sell some of its investments and, if a gain was created, distribute it to investors at year end if the net gains exceeded losses on all sold positions.

It is important to note that this only matters if a mutual fund or ETF is held in a taxable account, such as a brokerage account. If you hold these funds in a tax-advantaged account, like an IRA or 401(k), these tax implications are not applicable.

In closing

If you already have mutual funds in your taxable accounts, there’s no need to panic. By now, you may have seen significant gains on these investments over the years. If you continue to hold them, those gains will remain untaxed until you sell them. However, if you decide to sell these mutual funds to reduce your current capital gains, you may face a substantial tax bill that will substantially outweigh the benefits of mitigating capital gains incurred by other investors. Instead, you can now use this knowledge to make strategic investment decisions moving forward. 

At Lundeen Abrams Advisors, we prefer to create ETF portfolios for our clients and only utilizing mutual funds when we think they offer an advantage. If you are unsure how to structure your taxable investment accounts between ETFs and mutual funds, we are here to help. We regularly review existing investments for clients and help them create a strategy that will work best for them going forward. So, please reach out to us to setup a time today!