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September 28, 2019

ETFs May Be Better Than Mutual Funds, But …

Among the questions I’ve been asked many times over the years is whether it is better to own mutual funds or exchange-traded funds (ETFs). My response to each person who has asked it has consistently been to stick with the vehicle they find easier to use.

A study published in the September issue of the Journal of Banking & Finance sought to answer the same question. Rather than looking at mutual funds and ETFs overall, the authors focused on passive funds. Doing so provided more of an apples-to-apples comparison. Their conclusion? ETFs realize higher returns in aggregate.

Before dumping all of your mutual funds and switching to ETFs, look beyond the above summarization. The performance advantage of ETFs is very small: 1.615 basis points per month. Since 100 basis points equates to a single percentage point, the differential in returns is 0.01615% per month. This pales in comparison to the impact that your portfolio management decisions—allocation, when to buy and sell, etc.—have on your realized returns. Still, there are factors to consider when making the choice between a mutual fund and similar ETF.

For taxable accounts, there is an argument to be made for favoring ETFs. This is particularly the case if your income puts you into the 20% capital gains tax bracket and/or trust taxes are an issue. Taxes vary by fund category, with bond funds and foreign stock funds incurring more capital gains. Overall, the average passive mutual fund distributed 2.5% in capital gains versus 0.2% for the average ETF.
For tax-preferred accounts—traditional IRAs, Roth IRAs, etc.—capital gains distributions are not taxed and therefore are not a direct consideration. (They could be a sign to look at the level of portfolio turnover and a fund’s expense ratio.)

Transaction costs are an issue for ETFs. Because they trade like stocks, trading costs can reduce their return advantage. ETFs may also trade above or below their net asset value. Mutual funds, in contrast, are bought and sold at their net asset value at the end of a trading day. Mutual funds can also be purchased in fractional amounts. This is advantageous to those who are making regular contributions; especially those with smaller balances. ETFs must be purchased in whole share amounts.

It’s easy to overthink the choice. Rather than getting bogged down, put thought into what types of indexes you want exposure to (e.g., large-cap stocks, intermediate-term corporate bonds, etc.). Even seemingly small differences in how much you allocate to equities versus fixed income can influence your returns by 100 basis points (1%) or more—a far greater impact than making the choice between an ETF and a similar mutual fund.

The Week Ahead
Rosh Hashanah, the Jewish new year, will start on Sunday evening and run through Tuesday evening. L’Shanah Tovah to those of you observing the High Holy Days.
Several of the early reporters will announce their quarterly earnings. Included in this group are S&P 500 members McCormick & Company Inc. (MKC) on Tuesday; Jefferies Financial Group Inc. (JEF), Lamb Weston Holdings Inc. (LW), Lennar Corp. (LEN) and Paychex Inc. (PAYX) on Wednesday; and Constellation Brands Inc. (STZ), Costco Wholesale Corp. (COST) and PepsiCo Inc. (PEP) on Friday.

The week’s first economic report will be the September Chicago Purchasing Managers’ Index (PMI), released on Monday. Tuesday will feature the Institute for Supply Management’s (ISM) September manufacturing survey, the September PMI Manufacturing Index and August construction spending. The ADP’s September employment report and September vehicle sales will be released on Wednesday. Thursday will feature the ISM’s September non-manufacturing survey and August factory orders. September jobs data—including the changes in the unemployment report and nonfarm payrolls—and September international trade will be released on Friday.

Federal Reserve chair Jerome Powell will speak publicly on Friday. Other Federal Reserve officials scheduled to make public appearances are Chicago president Charles Evans on Tuesday and Thursday; St. Louis president James Bullard and governor Michelle Bowman on Tuesday; Philadelphia president Patrick Harker and New York president John Williams on Wednesday; Cleveland president Loretta Mester on Thursday; Atlanta president Raphael Bostic, governor Lael Brainard, vice chairman Richard Clarida on Friday; and Kansas City president Esther George on Sunday.

Courtesy of Charles Rotblut, CFA is the VP and Editor for American Association of Individual Investors (AAII). Charles is also the author of Better Good than Lucky
The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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