ETFs vs Mutual Funds

2024 is expected to be the first year that Exchange Traded Funds (ETFs) have net inflows exceeding $1 trillion in a calendar year. This compares to mutual fund net outflows of $150 billion. What has led to the increasing popularity of ETFs? And should anything be done with existing mutual fund holdings?

Similarities

At their core, ETFs and mutual funds share significant similarities. Both are investment vehicles that hold a wide range of assets, such as stocks, bonds, or commodities, allowing investors to diversify their portfolios without purchasing individual securities. These fund structures are often described as “baskets of securities” designed to meet specific investment objectives.

Like mutual funds, ETFs are overseen by professional portfolio managers. These experts monitor the stocks, bonds, or other holdings in the funds, saving investors time and effort.  

Both ETFs and mutual funds have an expense ratio, which reflects the costs associated with portfolio management, administration, and other operating expenses. This ratio is expressed as a percentage of the fund’s average net assets. For example, a fund with an expense ratio of 0.08% translates to $8 in costs for every $10,000 invested. These expenses reduce the fund’s assets, directly affecting investor returns.

Differences

Exchange Traded Funds (ETFs) provide several advantages over mutual funds:

• Trading flexibility: ETFs are traded on stock exchanges, just like individual stocks, so they can be bought or sold during market hours. Mutual funds orders are processed at the close of the market, leaving investors with uncertainty about what price they will get when they buy or sell shares.

• Transparency: ETFs typically disclose their holdings daily, allowing investors to monitor their portfolios more easily. Mutual funds, however, are only required to disclose holdings quarterly. While this increased transparency may not be crucial for all investors, it is a distinguishing factor.

• Tax efficiency: ETFs are generally more tax efficient than mutual funds due to their unique in-kind creation and redemption process that helps avoid capital gains distributions. Capital gains distributions are payments, like a dividend, representing a portion of the proceeds from the fund's sales of stocks and other assets from within its portfolio. These distributions are often unwanted as they impact an investor's taxable income, increasing their income tax liability and potentially impacting other things such as Medicare premiums or the ability to qualify for the clean vehicle credit.

• Cost: Most modern trading platforms allow ETFs to trade commission-free.

In Conclusion

Our investment approach at Luminvest Wealth Management involves using highly diversified, low-cost ETFs, especially because of their tax advantages for our high-net-worth clients. We help our clients manage or replace existing mutual funds in their portfolios, depending on what is best for their particular circumstances. ETFs can be a great choice for investors seeking a convenient, low-cost, and tax-efficient solution for building a well-rounded portfolio.

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