ETFs and mutual funds both offer diversification; however, each has its own distinct features. ETFs often generate fewer taxable events than mutual funds.
Repurchases by ETFs typically involve selling appreciated stocks and returning them directly to shareholders without taking capital gains tax into account, helping reduce taxes for investors.
Diversification
Divestment is key to managing risk and increasing returns when investing, whether through robo-advisors or directly in stocks. Diversification involves purchasing multiple investments that are uncorrelated, so that if one stock collapses you won’t lose all your money at once.
ETFs and mutual funds both provide instant diversification by being professionally managed collections (or “baskets”) of individual securities, yet there are differences between the two types.
ETFs trade throughout the day while mutual funds only sell at the end of each trading day, and have explicit costs like brokerage commissions and an operating expense ratio while mutual funds have implicit costs that result from bid-ask spreads. Investors should consider fees such as those for rebalancing; those looking for convenience might consider opting for target date funds that automatically rebalance for them; although these funds can be more costly overall.
Liquidity
ETFs trade on exchange based on their market price, determined by demand and supply in the secondary market. ETFs can be extremely liquid as long as authorized participants (APs) that play an active role in providing liquidity are able to meet both demand and provide supply in an ETF ecosystem.
ETF prices fluctuate throughout the day based on bid and ask prices displayed on public financial websites, which make up what’s known as the bid-ask spread. These fluctuations may lead to premiums or discounts relative to an ETF’s net asset value.
Liquidity can vary significantly among ETFs depending on their trading volume at specific times during the day; peak trading volumes typically occur during times when investors are more engaged with trading activities. Liquidity may also depend on which index or sector an ETF tracks; those that track more liquid markets typically provide greater liquidity.
Taxes
Mutual funds and ETFs offer numerous advantages over investing in individual securities, such as instant diversification, professional management, lower costs and daily liquidity. But both types of vehicles come with tax consequences that should be carefully considered before investing.
Mutual funds sell their holdings to raise cash, with any capital gains distributed as dividends and interest payments to shareholders – this distribution being taxed in full. ETFs on the other hand typically have lower internal turnover, using an in-kind creation/redemption process to minimize taxable capital gains.
Additionally, when purchasing ETF shares via your brokerage account, your broker handles record keeping, monthly statements, annual reports and 1099s – thus relieving the fund company of some cost burden and passing along savings in the form of lower expenses to investors. Furthermore, ETFs that invest in certain sectors follow sector-specific tax rules, resulting in potentially different tax treatments than others ETFs.
Fees
Fees associated with ETF and mutual fund investments can eat away at your investment earnings, so understanding their total costs helps make informed decisions about investments. Fees include expense ratios, trading commissions and bid/ask spreads – these all play a part.
ETFs generally feature lower fees than traditional index mutual funds and allow traders to invest without needing a set dollar amount upfront, making them ideal for dollar cost averaging strategies.
Investors should also consider the tax efficiency of ETFs when making their decisions. Unlike mutual funds, which must distribute capital gains directly to investors, ETFs offer investors more tax efficiency because they can sell shares of underlying holdings as they create or redeem new ones – this allows them to offset any capital gains accrued, thus reducing or even eliminating taxable distributions they must pass along to investors. It should be remembered however that ETFs holding securities with large gains may still incur tax obligations.
