First, let’s discuss what the two have in common. Usually, exchange traded funds (ETFs) and mutual funds are diversified. This means the funds hold the stock and / or bonds of many different companies. So, both represent good ways to achieve a diversified portfolio without having to buy hundreds or thousands of stocks and bonds yourself.
That said, ETFs do have some advantages over mutual funds. The advantages are:
- Lower Expense Ratios- Nowadays, investors can purchase ETFs with expense ratios of less than .1%. Meanwhile, the average mutual fund charges an expense ratio of 1.25%
- No Sales Charges- Some mutual funds have a sales charge, which is an additional charge that is applied when an investor buys or sells a fund. Many A share American Funds, for instance, currently charge a 5.75% sales charge on purchases. ETFs do not usually have such sales charges.
- Lower Transaction Fees- Mutual funds tend to trade more than index funds. Mutual fund companies must pay to trade; therefore, investors will pay transaction costs that are NOT included in the expense ratio. On average, mutual fund trading fees costs a fund investor another 1.44% a year while index fund trading costs are lower. In fact, mutual funds overpay for trades on purpose, in order to receive benefits; this complicated and underhanded practice is known as a “soft dollar arrangement” and you can read about it in this Investopedia article.
- Higher Tax Efficiency- ETFs are more tax efficient than mutual funds. This is because mutual funds pay out larger amounts capital gains to their shareholders every year. For instance, from 2000 to 2010, mutual funds paid out about 7% of their Net Asset Value to shareholders. During the same period, ETFs paid out capital gains of .02% of their Net Asset Value. While this might sound good, the ability of ETFs to retain this money is an advantage over mutual funds. Since ETFs are able to retain their earnings instead of paying them out, this results in less tax liability to owners of the fund. Note: This is only a tax advantage in non-qualified accounts.
For all of these reasons, I typically recommend ETFs over mutual funds. While everything has advantages and disadvantages, when it comes to ETFs, the advantages outweigh the disadvantages.