When you purchase exchange-traded funds (ETFs) through your broker, the single security actually represents ownership of several underlying investments. These funds have seen a dramatic rise over the course of the past two decades. Prior to the ETF, the only effective and accessible investment vehicle to achieve the same goal at this scale was the mutual fund.
Both ETFs and mutual funds can help you prioritize diversification on the path to retirement, but they carry different levels of tax efficiency. As you decide between ETFs vs. mutual funds, consider the taxable events you will encounter with each type of investment vehicle — as well as how they may affect your tax bill.
What Is an ETF?
An ETF is an investment vehicle that tracks an index or basket of assets. You can buy shares in the ETF just as you would any other stock, and they will trade like stocks during normal market hours.
As with any security, their price fluctuates based on supply and demand. ETFs can be passive investments, which automatically go to work for you in a basket of underlying assets as you invest your dollars.
ETFs may also invest in specific industries, sectors and indices. Their investment strategies vary — and, because of these various investment options, different ETF holders are charged different expenses for managing the fund's assets. Expenses typically include management, administrative and operational fees for the fund.
What Is a Mutual Fund?
Mutual funds pool your money together with money from other investors and then invest in a common portfolio of securities aligned with the mutual fund's investment objective.
A mutual fund is a collection of stocks, bonds or other securities purchased by many investors and managed collectively. They can either be actively managed with a professional investing team, which provides input to the fund's managers, or passively index-managed with minimal manager involvement.
Unlike ETFs, you can pick mutual funds from among different share classes, each with unique features, loads, expenses and operational fees. These combine to affect your basis in the mutual fund.
Mutual funds have the same expenses as ETFs but also come with a unique cost called 12b-1 fees. The mutual fund charges these fees to market and promote its funds to you and others. ETFs don't encounter these 12b-1 fees, because you can buy and sell them openly on an exchange throughout the day.
Mutual funds also come in two varieties: closed-ended or open-ended. Closed-ended mutual funds act more like ETFs — they issue a fixed number of shares through an initial public offering and then trade openly on the market like an ETF. Open-ended mutual funds continuously offer new shares to the investing public or redeem them from selling investors. They don't limit the number of shares they can issue.
If you sell a large enough amount of shares back to the mutual fund in a redemption, the fund may need to sell some of the underlying assets to repay you.
Weighing the Pros and Cons of ETFs vs. Mutual Funds
Comparing ETFs vs. mutual funds will highlight a number of similarities. Qualities like diversification, the ability to track indexes and relatively low fees make both of these investment vehicles attractive for those planning for retirement.
Looking deeper into their differences can help you decide which option might fit better in your overall portfolio and set of accounts. If you own ETFs or mutual funds in a taxable account, how they handle capital gains may affect your tax bill each year through their different tax efficiency.
In general, these differences diminish in a tax-advantaged account like an individual retirement account (IRA) or 401(k). In these accounts, you have either deferred taxes until a later date through a traditional account or have your investments grow tax free in a Roth account.
ETFs have many pros, including that they:
- Trade like a stock on an exchange during normal market hours.
- Represent instant portfolio diversification through the purchase of several underlying assets.
- Typically have lower fees than a traditional mutual fund and can be bought on margin.
- Are more tax efficient than mutual funds due to their closed-end nature (no further issuance or redemption).
- Have low barriers to entry, only requiring enough money to purchase one share.
They can also carry cons:
- Must pay the "bid-ask spread" like with stocks, which can amount to wider spreads on low-volume, narrowly traded ETFs (although this is generally not an issue with broadly traded index ETFs).
- Have possible trading commissions on trades.
Likewise, mutual funds are popular for their benefits:
- Provide diversification through the purchase of several underlying securities simultaneously.
- Don't have costs for the "spread" between bid and ask, as with ETFs.
- Have no trading commissions.
Yet they have their own drawbacks:
- Only trade during one window at the end of the market day.
- Are traded not at a price but as the Net Asset Value (NAV) of the underlying securities.
- Cannot use different types of orders to buy or sell mutual funds like limit orders, stop-loss orders, etc.
- Tend to have higher expense ratios than ETFs.
- Can have sales loads and higher investment minimums than ETFs.
ETFs vs. Mutual Funds: Which Are More Tax Efficient?
These two investment vehicles also share similarities in some elements of their tax efficiency. For example, you must pay taxes when you sell your investments — how much you pay will depend on how long you held the investment.
If you sold an investment you've owned for less than a year, you'll pay taxes at your ordinary income tax rate. Conversely, if you sold your investment after holding for at least a year, you pay long-term capital gains taxes, which are usually lower than your usual tax bracket. Below certain income levels, you don't pay taxes on long-term capital gains.
Because ETFs tend to be more passively managed, they have lower portfolio turnover. Non-index mutual funds have active management, and so they create more capital gains due to management's investment activities.
ETFs have active management in some cases as well. Though less common, these ETFs, and even some index fund ETFs, can trigger capital gains distributions. If you receive capital gains distributions from either investment, they receive long-term capital gains treatment regardless of how long you owned the shares.
Because ETFs tend to pay these distributions less often, this makes them more tax efficient in most cases than mutual funds. You then have more control over when you want to realize capital gains.
One last thing to note is that this distinction doesn't matter in tax-advantaged accounts. If you have a traditional retirement account, you won't pay taxes on these funds until you withdraw them in retirement. If you have funds invested in a Roth account, they grow tax free.
How Should You Invest for Retirement?
ETFs act similarly to mutual funds, but they trade like stocks, tend to have lower fees overall than traditional mutual funds and carry greater tax efficiency. Both investment vehicles act as smart long-term investments for individuals looking to keep their costs down while investing in a diversified mix of various asset classes such as stocks or bonds.
When you invest through a retirement account, the only difference to consider comes from the overall expense ratio. If you have the ability to purchase identical investments either as an ETF or mutual fund, compare the expenses and any taxes you may need to pay before moving forward.
In most cases, the difference amounts to little. Either account will serve to put forward diversified investments for the long term, allowing you to grow your nest egg and protect your financial future.