Exchange Traded Funds (ETF) and mutual funds may both be viable choices for investors. The differences and similarities in these two investment vehicles are many. Knowing the goal of the client will help you decide which one to use and when.
Both offer flexibility, diversification, and the potential to provide positive returns over a long period of time. But there are differences that need to be considered. ETFs are bought and sold during the trading day, similar to the manner in which equities are traded. Because of the way ETFs trade, the price at which any particular order is executed may be higher or lower than the NAV of the underlying asset, (similar to a closed-end mutual fund). Traditional mutual funds are traded once a day, but the actual trade doesn’t occur until after the markets close. Therefore, the investor knows that his transaction will occur at the fund’s actual net asset value, (after adjustment for any applicable fees or charges, as described in the fund’s prospects). ETFs tend to represent indexes – entire markets or market segments. The managers of these passively managed ETFs do very little trading of securities in the ETF, which may help to keep internal expenses low.
ETFs appear to have an annual ongoing cost advantage over mutual funds. According to Investopedia, the average stock fund charges an advertised fee of 1.3-1.5 percent. In comparison, many exchange-traded funds are less costly than mutual fund. According to the Wall Street Journal, ETFs boast an average expense ratio of 0.44 percent, which all things being equal, could potentially keep more money in your client’s pocket.
Regarding the cost to your clients of purchasing ETFs versus Mutual Funds, the cost structure can differ dramatically. Loaded mutual funds have various share classes which can include upfront and/or back-end sales charges. However, most no-load mutual funds do not have these sales charges. ETFs on the other hand, don’t have sales charges, but do have a bid/ask spread. The “ask” (or “offer”) is the market price at which an ETF can be bought, and the “bid” is the market price at which the same ETF can be sold. The difference between these two prices is commonly known as the bid/ask spread. You can think of it as a transaction cost similar to commissions or sales charge except that the spread is built into the market price and is paid on each roundtrip purchase and sale. So, the larger the spread and the more frequently you trade, the more relevant this cost becomes.
Because of their typically low portfolio turnover and the way they are structured, some ETFs have the potential to offer greater tax advantages to investors over mutual funds because they may generate a lower level of capital gains. As passively managed portfolios, ETFs (and index funds) tend to realize fewer capital gains than actively managed mutual funds. Investors should know that ETFs clients will still owe taxes on the distributions of dividends or interest income that an ETF receives and passes through to investors. They also will face capital gains taxes when selling, regardless of whether the fund is an ETF or index mutual fund.
With so many ETFs and mutual funds available on the market, it’s important for independent financial advisors and investors to familiarize themselves with the differences between the products to ensure they are making appropriate investment decisions. Summit Brokerage’s Marketing Department and Trading Desk can help advisors sort through these investment vehicles to develop the best strategies for your clients.