ETFs, or Exchange Traded Funds, first arrived on the stock market in 1993. Since their introduction, they’ve gained more popularity due to their usually lower fees and the tax efficiency they offer in comparison to mutual funds. Many investors looking for mutual fund alternatives claimed that ETFs would replace them over time—is that so?
For now, ETFs are not replacing index mutual funds. Investors may want to consider diversifying their portfolios with mutual funds and ETFs because index mutual funds tend to perform better than ETFs when they are managed correctly.
Here’s everything you need to know about ETFs and index mutual funds, so keep reading!
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Why ETFs Aren’t Replacing Index Mutual Funds
In December of 2018, 8,059 mutual funds held $17.71 trillion, while ETFs held a total of $3.37 trillion in 1,988 ETFs. With all of these people investing in mutual funds, it’s doubtful they’re going to be replaced by ETFs suddenly.
However, ETFs are the best choice for day trading. This feature comes from the fact that ETFs can be sold short, like a stock. However, if you’re not interested in day trading, you may want to consider choosing other investment options instead, such as mutual funds.
Both index mutual funds and ETFs make it easy to diversify.
While ETFs are simple to trade during the day, like a stock, you can only buy mutual funds at the end of the trading day. Additionally, you’ll need to have an active part in managing your mutual funds.
ETFs are usually much more passive than mutual funds, making them more appealing to more people. This option is also more cost-efficient since they don’t need a fund manager to watch over them.
Overall, ETFs and mutual funds can serve different purposes. There isn’t a need for one of them to completely replace the other at this time.
Plus, mutual funds contain more investment assets.
Comparing ETFs to Index Mutual Funds
While there are plenty of similarities between ETFs and Index Mutual Funds, there are also many differences, which you’ll want to consider when choosing an investment option for yourself. Let’s take a look at how the two compare.
Exchange-Traded Funds (ETFs)
ETFs have a lower minimum investment. The shares are then traded throughout the business day as though they’re stocks. You can even sell an ETF short, making it unnecessary to hold onto for an extended amount of time.
However, ETFs are perfect for day trading because of this.
Most importantly, the market constantly prices ETFs during the business day. That means you can trade above or below the ETF’s initial worth, and many investors use this to make several small profits during the day.
If you’re interested in understanding the fundamentals of ETFs, I recommend the Investing in ETFs For Dummies guide from Amazon.com. The book teaches you how to diversify your investment portfolio and has everything you need to know to start trading ETFs on the market.
If you’re searching for an easy guide, it’s a great place to start.
It’s worth noting that you’ll want to manage your ETFs often. Letting them alone quickly leads to decreases in potential revenue. Many investors are very active with their ETFs and trade them frequently.
Mutual funds are more expensive since they usually have a higher minimum investment requirement, which can get relatively high with certain companies. Additionally, mutual funds need to be actively managed by a fund manager whose primary goal is to make their investors a profit.
Since these mutual funds need constant management during the day, the prices go up. And because a fund manager always keeps an eye on the stock, you will need to pay that person for their time.
The money may come in the way of fees.
Overall, the price of your mutual fund changes until the end of the trading day. At this point, its net asset value, or NAV, is set.
Why Some Investors Still Prefer Mutual Funds?
Investors still prefer mutual funds over ETFs for the following reasons:
- All transactions take place at NAV.
- Dividends reinvest quickly.
- Fractional shares are available to buy.
- It’s tax-free to change mutual funds into ETFs, but not the other way around.
Since it’s tax-free to turn your mutual funds into ETFs, many investors do it at some point. This fact tends to make it appear as though ETFs are replacing funds since no one’s making the change the other way around.
However, people tend to avoid turning ETFs into mutual funds, so they won’t have to pay additional taxes.
These benefits allow mutual fund holders to plan, prepare, and make financial moves with ease. Many investors also enjoy the tax efficiency that comes with mutual funds.
Overall, you’ll need to consider what you want out of your assets before buying shares.
Mutual Funds in Retirement Accounts
It’s also worth knowing that retirement accounts consist of mutual funds. Most retirement plans use a 401(k), which revolves around mutual funds.
Currently, there isn’t much room for ETFs working in a retirement plan, unless you create your own portfolio.
Overall, ETFs aren’t likely to replace mutual funds when it comes to retirement accounts. The 401(k) system has a basis in using mutual funds to invest, and they work well for retirement, meaning there isn’t a need to swap them out.
Why Do Many Investors Prefer ETFs?
You’ll need to consider what you want the most from your investments. If you aren’t interested in day trading and prefer something long-term, then mutual funds are the better option for you.
Additionally, you won’t have to pay as much for the initial investment.
However, the final choice usually comes down to the capital gains taxes you’re required to pay on your investments. ETFs are much more tax-efficient than mutual funds, and when you sell your ETF, you’re selling directly to another investor.
The taxes you pay only come from those transactions, and not for every other investor’s sales.
However, when you want to sell a mutual fund, you need to first go through the fund manager. Then, the manager will sell your fund, but the net gains also go to every other investor who has shares in the fund.
That means another investor in the pool must pay net gains taxes for the added amount. If you have mutual funds, you can’t be sure when the other investors will sell their shares- meaning you could potentially have to pay capital gains taxes at any time.
Those who prefer ETFs also enjoy not having to deal with capital gains taxes unless they’re the ones making the sales for profit. This factor usually is what causes investors to choose ETFs over mutual funds.
Overall, ETFs are much better if you don’t want to deal with taxes as often. This feature is the ETF’s most significant benefit, so you’ll want to spend time considering it.
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Both ETFs and mutual funds come with their own benefits.
You can use both at the same time to further diversify your portfolio. It’s improbable that ETFs completely replace mutual funds, so you won’t have to worry about that happening.
Many investors enjoy mutual funds for their tax efficiency. While they tend to cost more than ETFs, you can still find affordable options in each category. It’s best not to consider one investment type better than the other, as they’re both excellent options for different reasons.
You’ll want to carefully consider what you want out of the shares first.
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