One of the questions that we frequently get is whether or not there is an advantage for long-term investors to use exchange traded funds instead of index mutual funds. It’s an excellent question, to be sure.
Many investors who have been using traditional open-end mutual funds are probably less familiar with ETF’s and tend to shy away from using them. However there are a number of compelling reasons to choose an index based ETF over mutual fund and this blog is going to look at several of them. Enjoy.
One important advantage is that, even though traditional mutual funds and ETF’s hold identical baskets of securities and track the same indexes, ETF’s usually cost less. The reason is that they aren’t forced to pay an army of customer service personnel and lots of other administrative expenses. Like traditional mutual funds do.
Another advantage that ETF’s have over traditional mutual funds (although a bit less obvious) is that when an investor decides to sell their ETF shares, their shares are simply purchased by another investor with no need to sell any holdings and thus no capital gains are generated by the transaction. This simple fact reduces future tax costs for the shareholders. (However, in some cases, a traditional index mutual fund can be just as tax efficient if it’s run properly.)
The fact that ETF’s can be bought and sold while the market is still open (just like stocks) is another definite advantage for investing in them. Traditional mutual fund shares can only be bought and sold after the market closes and it’s for this reason that ETF’s are sometimes associated with market timing and day trading. For long-term investors who want to be able to move their money in or out of the market (in the case of a sharp downturn) and ETF can provide is extra advantage.
One caveat is that a person who invests heavily in ETF’s should be aware that impulsive decision-making is a problem, especially during times of market turmoil. The fact is, not being able to trade while the market is open (and emotions are still running high) can actually sometimes be an advantage. If you tend to make rash decisions based on what the markets doing on a daily basis, it’s possible that you might want to avoid ETF’s.
One final thing that you may want to consider when you’re weighing the difference between ETF’s and index-based mutual funds is that not all of them have a counterpart. While it’s true that many of the most commonly used indexes are available in both mutual funds and ETF’s, some of the more esoteric options may be only available in either one form or the other. That being said, there’s no reason that you can’t choose some ETF’s for your index-based investments and choose traditional mutual funds for others. That’s an excellent way to customize and diversify your portfolio to best suit your investing needs.
If you have questions about personal finance and investing, please let us know and we’ll get back to you with advice and answers right away.