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Exchange-traded funds (ETFs) are sweeping the investment universe these days. They are even beginning to encroach on that time-honored turf of the mutual fund: the IRA.

Investors are finding they can save money by funding their accounts with ETFs rather than stocks or mutual funds—at least a little—and that “a little” can eventually make a huge difference if you’re investing for the long-term, as retirement-account holders tend to do. Let’s examine why and how ETFs are often the better choice.

What Is an ETF?

 

But first, let’s review the basics. An exchange-traded fund is a kind of cross between a stock and a mutual fund. As the name implies, it is a marketable security that trades daily, like shares of a stock. Like a mutual fund, it holds a basket of assets.

The composition of the fund, and thus its performance, are closely correlated to an underlying index, market or type of investment vehicle. It can be based, for example, on a specific stock-market index, like the S&P 500, an industry sector, or a commodity such as oil or gold. In today’s diverse investment environment, there’s an ETF for nearly every equity sector, commodity or individual market exchange, including foreign exchanges.

In contrast to mutual funds, ETFs are minimally, also known as passively, managed. They are meant to be pure plays on a given index, sector or commodity, so the activities of their managers are generally limited to maintaining the necessary composition in the fund. Their purpose is not to outperform the market, index or asset they track, but rather to closely match its performance.

ETFs vs. Stocks

Paper listing information about stocks, etfs, and investment information.

ETFs offer a notable cost advantage over stocks. Diversification is a major factor with investing, and it’s easy to accomplish with ETFs, especially since they’re generally tied to various indexes that enable you to diversify either within a given market or within a specific industry group.

You’d have to buy a lot of individual stocks in order to obtain that level of diversification, and the transaction costs for doing so would be significant. What’s more, because they are trading large blocks of equities, a stock-based ETF will be less expensive to buy and sell than a comparable dollar value of individual stock positions

ETFs vs. Mutual Funds

ETFs have several advantages over mutual funds, and they can be significant.

Real-time trading and liquidation

When you trade mutual funds—whether you’re buying or selling—the price you get is the fund’s closing price at the end of the trading day. On an ordinary day, this limitation doesn’t have much effect. But on those days where stocks and other investments are either rising or falling rapidly it can make a substantial difference.

If, for example, you decide to buy shares of a mutual fund first thing in the morning, but the market rises 5% during the course of the day, you will pay a higher price at the close, not the lower price from earlier in the day. The same will be true on a day when the markets close down by similar percentages.

With ETFs, you trade in real time: That is, you get the price at the time your order is executed, regardless of when it happens. This gives you more control over the trading process and the prices at which you expect to buy and sell.

Saving on income taxes

Because mutual funds are actively managed by fund managers who are working to achieve the best investment returns possible, they tend to create tax liabilities. Fund managers like to sell stocks at a profit, which is the source of the “capital gains distributions” that show up on the 1099 forms you receive from the fund companies at tax time. You may not have sold any of your mutual funds shares during the year, but any individual security sales within the fund itself will still create a capital gain (if the sale was profitable, of course).

ETFs don’t buy and sell shares to produce gains, but rather to maintain the correlation with their underlying index within the fund. That means far less trading, and a far lower likelihood that capital gains distributions will be incurred. This lower incidence of capital gains taxes can not only lower the expense of investing through ETFs compared to mutual funds, but it can also have a material effect on investment performance over many years.

Admittedly, this isn’t a factor for tax-sheltered retirement plans, but they can be substantial for your non-sheltered investments, or if there’s a possibility you might need to withdraw funds pre-retirement from an IRA.

Hands-off management

This touches on the whole passive-vs-active management debate currently raging in the financial industry, which is beyond the scope of this article. Suffice to say, that when active fund managers are good, they’re very, very good at beating the market. But the fact is that most mutual funds fail to outperform the indices in their respective markets and sectors, and many even underperform them.

And whether the fund outperforms, matches or underperforms the market, you’re paying for that management. ETFs are essentially a play on the sector, market or commodity, so you’re at least guaranteed to match the market—and that’s better than many professionally managed mutual funds do. Plus, you aren’t paying extra for it.

Saving on management fees and fund expenses

Since ETFs have are passively managed, it follows the management fees will also be lower than they will be with actively managed mutual funds. Passive management just costs less.

Mutual funds also have 12(b)-1 fees (annual marketing or distribution fees normally amounting to .25 to 1% of the fund’s value. They may be small, but they can add up over 20 to 30 years. Mutual funds sometimes have redemption fees on the back end, when the fund’s positions are liquidated, and those fees are more substantial, usually several percentage points. ETFs have neither, which can increase your rate of return, especially over the long term.

Drawback to ETFs

If you gradually increase your various holdings by, say, dollar-cost averaging out of payroll deductions or some other form of regular contribution, ETFs may not be the best choice. ETFs involve broker commissions (though some firms waive these, especially with proprietorial funds), so you will pay more in commissions than you would with mutual funds.

Since you’re investing directly in the mutual fund, you generally will not have to pay a fee each time you add to your holdings. With ETFs, not only will you pay a brokerage fee each time you buy or sell, but you’ll also pay a spread (as you would with individual stocks), which is the difference between the bid and ask price. These may not amount to much on any individual trade, but it can be substantial if you trade in small blocks many times over the course of a year.

When are you better off with ETFs?

So should you switch your portfolio from mutual funds to ETFs? Consider ETFs in any of the following circumstances:

  1. You’ve discovered—as many investors have—that most mutual funds you’ve been in either don’t outperform the market or have underperformed it.
  2. You’re a true long-term investor, taking various positions and staying with them for years at a time. This is especially true for the very long-term horizons that retirement investing involves.
  3. You tend to buy large positions, rather than gradually accumulating them.
  4. You prefer greater control over your annual income tax liability.

Should you invest only in ETFs?

No, of course not. While ETFs offer a definite cost advantage over individual stocks, having a few individual positions in your portfolio may allow you to take advantage of special situations that funds of any sort can’t provide.

Similarly, you shouldn’t turn your back on a mutual fund that fits your portfolio perfectly or in some unique way, just because of fees. You want to reduce any costs associated with investing—retirement investing in particular—but what you’ll save won’t make or break your investment performance. And because ETFs and mutual funds are locked in an ongoing competition for the investor’s dollar, the difference in fees may well narrow going forward.

When it comes to retirement investing, the most important goal is to end up with a portfolio that is both properly invested and adequately diversified.

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