Today, I'd like to compare and contrast ETF's and standard Index Mutual Funds. In order to do this objectively, one must investigate the following characteristics of each investment:
- Cost Efficiency
- Tax Efficiency
Cost Efficiency:
ETFs have a lower expense ratio (operating costs) than Index Mutual Funds. Therefore, they are cheaper to hold. However, investors pay commissions when buying shares of an ETF which is an additional expense that Index Mutual Funds don’t involve. Only when ETFs are bought in large sums with low price commissions and held for the long term (aka investing) are they more cost efficient than Index Mutual Funds. Unfortunately, many investors give in to their anxiety and/or greed and start trading ETFs like individual stocks, therefore depleting any returns that they could have achieved if they had bought and held.
Tax Efficiency:
ETFs win again in tax efficiency. ETFs are slightly more tax efficient than Index Mutual Funds. This is because of how they are created and redeemed. With ETFs, most of the capital gains are deferred until the date they are sold. This advantage is similar to the advantage that tax-deferred retirement accounts (401Ks & IRAs) offer. Don’t rule out Index Mutual Funds just yet, because they are still significantly more tax efficient than actively managed mutual funds.
Note: The degree of these advantages are subject to the investor’s marginal tax rate, how long the investment was held and the return on the investment.
