What is an Exchange Traded Fund?

An exchange traded fund (ETF) is a security that tracks an index or holds a defined basket of securities. ETFs may contain a wide variety of securities including stocks, bonds, and commodities. ETFs trade like stocks on a stock exchange. You can buy or sell an ETF any time when the market is open.

How Does This Differ From a Mutual Fund?

Mutual funds do not trade during the day. Each day, the sponsor of the mutual fund determines the net asset value (NAV) of the assets at the close of the day. All buy and sell requests that come in that day will receive the NAV price for that day. Certainly there is a convenience factor in being able to buy and sell ETFs throughout the day. Practically speaking, in an investment portfolio where there are limited changes to the model portfolio and rebalancing occurs infrequentyly (e.g. quarterly), the convenience benefit of being able to trade the ETF throughout the day may not be a critical factor.

What are the Tax Differences Between Exchange Traded Funds and Mutual Funds

Based on the way ETFs and mutual funds are structured, there are significant differences in the tax implications of holding each. In the US, taxes are paid on interest, dividends and capital gains. Let’s focus this discussion on the capital gains element. (ETF and mutual fund interest and dividend distributions are handled in a similar manner.)

What triggers a capital gain and thus possible tax? There are three cases where a capital gain may be realized. First, if the mutual fund or ETF buys are sells a security and there is a gain, we would have a tax impact. If the fund is tracking an index, there may be limited trading for rebalancing to the index. This type of fund is consider a ‘passive’ fund and the gains are typically low. Funds that take an active investing style may incur more gains. These gains are passed on to you.

The second case where a gain may be incurred is where you sell the fund itself and incur a gain from the point of purchase. Both the ETF and the mutual fund would report the gain and you would have a tax liability.

The third case is where the ETF and the mutual fund differ. If other investors make exchanges in the fund, the mutual fund may need to sell securities and then it passes on those gains to you, even though you did not sell any of your fund shares. In the case of an ETF, no such gains would be passed on to you. (The mechanics of how this occurs goes beyond the scope of this paper. The key thing to remember is that the structure and rules for how an ETF and mutual fund reports gains is diferent).

As a result of this third case, ETFs are seen as a more tax efficient way to invest.

Two points need to be made here. First, if the fund is held in a tax deferred account, the difference is these gains will not affect taxes. Second, earlier I noted that some funds hold securities that they trade infrequently (‘passive’ funds) and others have strategies where they trade more frequently (‘active’ funds). Because both ETF and mutual funds would likely incur more gains with an ‘active’ fund, it is important to consider the fund investment strategy along with the structure (ETF or mutual fund).

What Costs Are Involved in Using Exchange Traded Funds vs. Mutual Funds

As mentioned, ETFs trade like a stock on an exchange. The costs involved will be similar. First, there will be a trading charge each time you buy/sell. With discount brokers, such as Scottrade, you can trade an ETF for around $7. Generally, to keep costs down, I like to set trade minimums to $2,000. The effective cost of the trade woud be: $7 / $2,000 = .35% in commission costs. For mutual funds, Scottrade offers many ‘no transaction fee’ funds (‘NTF’ funds). For other mutual funds trades will run $17.

This is not the end of the story. One cost that is often overlooked with ETFs is the ‘bid-ask’ spread. When trading on an exchange the price is expressed in the highest ‘bid’ and the lowest ‘ask’. For example, the highest ‘bid’ for a fund may be $9.98, while the lowest ‘ask’ may be $10.02. In this case, we see that we would need to pay $10.02 to buy a fund and the same fund could be sold for $9.98. So, you can see that if we immediately bought and sold the fund, we would incur a hidden cost of $.04. The implied cost of the ‘bid-ask’ spread is $.04/$10.00 = .4%. Generally, for ETFs that are widely held and trade frequently, the ‘bid-ask’ spread will be smaller. It’s important to understand the ETF product and it’s ‘bid-ask’ spread to get an idea of the total costs. In addition, the price the fund trades at may be at a ‘premium’ or ‘discount’ to the true net asset value of the securities in the fund. This too, needs to be considered.

This discussion did not go into details regarding the internal expenses being charged by the fund itself. Both mutual funds and ETFs have fund expenses that also reduce overall return. According to Morningstar Research article: “2015 Fee Study: Investors Are Driving Expense Ratios Down” , the average expense ratio for ETF and mutual funds in 2014 was .67%. Fund expenses are on a downtrend and investors are putting more money into the lowest expense ratio funds. It is important to note that ‘active’ funds generally carry a much higher expense ratio (.8%) while ‘passive’ funds average of .2%.

Generally, we avoid funds with high expense ratios. For mutual funds we avoid funds with load charges and focus on intsitutional class shares with the lowest expense ratios. In the ETF categories we are generally using index products with expense ratios below the .2% average. In some cases, we are using semi-active funds that use ‘smart beta’ fundamental approaches. These funds have higher expense ratios, but generally lower than the average passive fund ratio of .8%.

Should You Use Exchange Traded Funds or Mutual Funds Exclusivesly?

As this article has demonstrated, there are several signficant factors to be aware of when selecting between ETF or mutual funds. First, the investment strategy must be considered. Second, the total cost of owning the fund needs to be understood. Finally, the tax implications of the fund needs to be understood. The fund selection typically will be taylored for the individuals circumstances. For example, we may find the risk-adjusted return of an active mutual fund attractive. The after-tax implications may be managed by placing these assets in a tax-deferred account (401k or IRA).

If you have questions regarding the expenses, trading costs and tax implications of any securities, ETF or mutual fund products you may hold, please give us a call and we will be glad to help.