Building a Portfolio with ETFs or Mutual Funds
Etf.com recently quoted me in their article The Case for ETFs Over Mutual Funds Gains Steam. It wasn't until that publication I realized how many investors use ETFs and mutual funds interchangeably. So, I decided to publish this blog to highlight how overlooking some of the key details between investment vehicles can cost you thousands of dollars.
As an independent firm, we can evaluate the entire universe of investment securities with no allegiance to proprietary products or fund companies.
With all this freedom, we choose to structure client portfolios with low-cost, passively managed ETFs.
The rest of this post shows you exactly why we prefer ETFs over mutual funds and passive management instead of active management.
While we believe in this strategy and the logic behind it, everyone should have their situation evaluated by their personal financial professional, as this is not investment advice.
ETF & Mutual Fund Background
ETFs and mutual funds provide investors with easy diversification by pooling hundreds or even thousands of individual stocks, bonds, commodities, etc.
Shares of the ETF or mutual fund represent exposure to the fund’s underlying investments. The fund’s share price reflects the value of those securities.
Both ETFs and mutual funds can be actively or passively managed, which brings us to the first debate.
Actively managed funds try to outperform an index by choosing securities based on the fund manager’s evaluation of a company’s competitive advantages, investment style, momentum, etc.
For example, a manager trying to outperform the S&P 500 may choose to hold more of a particular company’s stock compared to the index because they believe the company will outperform.
So, if a stock comprises 2% of the index, the company may decide to hold 4% in its portfolio and hold 2% less in one or more of the other companies.
Passive investments track an index like the S&P 500 or the Bloomberg Aggregate Bond Index.
For example, the S&P 500 is comprised of the 500 largest public US companies based on market cap (outstanding shares x share value).
So, if an investment tracks the S&P 500, it will only make changes to its holdings when the index makes changes.
Active vs. Passive Taxes & Fees
Actively managed funds are typically more expensive and less tax-efficient.
The fund manager and their team spend thousands of hours trying to identify securities they believe will outperform, so fund expenses are higher to compensate them for their efforts.
Active funds trade more frequently than passive funds, which triggers more taxable events that are passed on to shareholders.
Active vs. Passive Performance
Consumers usually require better quality or more value in exchange for a higher price. So, in theory, it’s reasonable for investors to expect higher returns for a more expensive investment product. In reality, that’s usually not the case.
In any given year, a portfolio manager may outperform the benchmark index. But wealth is grown over a span of years, not one. So, we must focus on long-term performance.
Viewed through a long-term lens, the data favors passive management.
Source: S&P Dow Jones SPIVA Report
ETF & Mutual Fund Differences
We’ve stated our case for passive management, now we’ll explain why we’re partial to ETFs over mutual funds.
The structural differences between ETFs and mutual funds are complex, but what’s important is how these differences trickle down to the individual investor.
From trading frequency, tax efficiency, expenses, and more, what may seem like an inconsequential decision can have significant downstream effects.
Trading ETFs & Mutual Funds
ETFs can be bought and sold throughout the day like an individual stock, while mutual fund shares are only traded once per day after market close.
This means one ETF investor will likely pay more or less for a share than another investor who buys at a different time on the same day. Since mutual funds only transact after market close, all investors who placed an order that day will have it filled at the same price.
All else equal, ETFs are generally more tax-efficient than mutual funds.
When mutual fund shareholders redeem shares, the fund manager must rebalance the portfolio to generate cash for those redemptions. These sales generate capital gains/losses that are passed onto shareholders regardless of whether they personally sell shares.
ETFs are structured to avoid these types of distributions, but they still pay dividends and interest.
*Important: Tax efficiency is only relevant for securities held in taxable brokerage accounts*
Mutual Fund Distribution Example
While it’s an extreme case, Vanguard’s Target Retirement 2035 & 2040 funds distributed ~15% of their total assets as capital gains at the end of 2021.
Target Date funds are typically held in tax-deferred retirement accounts where there would be no immediate tax impact, but those who owned the funds in a taxable brokerage account had a rude awakening.
Returns After Taxes & Fees
Most investors judge a security by its gross return. But the after-tax, net of fee return, should be paramount since this is what they actually get to keep.
Fractional differences that equate to less than 1% may not seem relevant today, but over decades, it can be the difference between an early or delayed retirement.
The good news is taxes and fees are two of the variables we have the most control over.
Tax drag measures the percentage reduction in a portfolio’s annualized return resulting from the tax liability generated by distributions like taxable interest, dividends, and capital gains.
Minimizing the number of taxable events (uncontrollable distributions) throughout the life of an investment reduces the tax paid and leaves more money to compound.
As mentioned, ETFs don’t make capital gain distributions like mutual funds. So, if gross returns are equal, the ETF’s after-tax return would be superior.
It’s difficult to make an apples-to-apples comparison of costs between ETFs and mutual funds because the exact costs depend on various factors unique to the specific fund.
For example, many mutual funds offer several share classes with varying expense ratios, sales charges, and redemption fees, so the exact cost depends on the share class purchased.
ETFs don’t typically carry sales loads or redemption fees, but funds with the same investment exposure often have varying expense ratios. In addition, ETF investors pay a bid/ask spread that mutual fund investors aren’t subject to.
Most of these costs must be evaluated on a case-by-case basis, but expense ratios can easily be compared and have a significant impact on long-term wealth.
Expense Ratio Example
Consider two funds, both tracking the S&P 500, but one has an expense ratio of 0.03%, and the other has an expense ratio of 0.20%.
A mere 0.17% difference in expense ratio costs you an extra ~$35k for the same exact investment exposure.
In most cases, successful investing depends less on the complexity of your portfolio and more on your management of controllable variables that are overlooked by the masses.
Subtle differences like management style, taxes, and fees compound to have a material impact on wealth accumulation over long periods.
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