The Right Time To Change From Mutual Funds to ETFs (2024)

Mutual funds have long been a popular choice for many investors because of the wide range of options available and the automatic diversification they offer. However, depending on what you want to get out of your portfolio and your risk tolerance and investing strategy, it may be time to switch from mutual funds to exchange-traded funds.

Mutual funds and exchange-traded funds (ETFs) share many benefits. In addition, ETFs are generally more tax-efficient and affordable than traditional mutual funds. Like any investment product, ETFs still have their drawbacks. A clear understanding of what ETFs can offer and what type of investor they are best suited for will help you determine whether they may be a smarter choice for your portfolio andcurrent investment goals.

Key Takeaways

  • Investors have been utilizing mutual funds for professional portfolio management for decades, but mutual funds have some drawbacks.
  • Exchange traded funds (ETFs) have gained favor over time, as they behave much like mutual funds but solve several of these drawbacks.
  • ETFs, which trade like stocks, tend to be less expensive to own, have greater liquidity, and are more tax efficient than their equivalent mutual funds.

Understanding ETFs

ETFs are effectively mutual fundstraded on the open market. Like mutual funds, ETFs pool contributions from shareholders and invest in a range of securities. Also, like mutual funds, ETFs may invest in different securities depending on the goals of the fund in question. Unlike mutual funds, however, ETFs are primarily passively managed funds that generally invest in the same securities as a given index.

Investors can buy and sell ETFs on the secondary marketlike stocks or bonds, making them highly liquid. In addition, the market-based trading of ETFs means no assets need to be sold off to fund shareholder redemptions, as is common with mutual funds. ETFs can also use in-kind distributionand redemption processesin which the investor issues or redeems shares of the ETF in return for a basket of stocks corresponding to the fund's portfolio, rather than for cash.

Advantages of ETFs

Among the many advantages of ETFs is their relatively low expense ratios compared to similar mutual funds. Of course, those ETFs that are actively managed do incur slightly higher costs but are generally still lower than mutual funds. ETFs don't carry load or 12b-1 fees like mutual funds do, though buying and selling shares does incur commission charges like any other trading activity. However, if you are looking to make a single large investmentrather than several small purchases over time, ETFs can be vastly more affordable than mutual funds.

In addition, the passive investment strategy employed by most ETFs makes them highly tax efficient. Because these funds don't make many trades, the odds of an ETF making frequent capital gains distributions are low. Any time an investment pays capital gains or dividends, it increases each shareholder's tax liability. Because ETFs make fewer distributions, they are more tax-efficient than mutual funds.

The fact that funds aren't typically required to liquidate assets to cover shareholder redemptions (since shares can be bought and sold on the open market or redeemed for baskets of stocks) further decreases the tax impact of ETF investing.

$22.1 Trillion

The total assets under management of all U.S.-registered mutual funds as of 2022, according to Statista. In the same year, ETFs had a combined AUM of $9.6 trillion.

Who Are ETFs Best Suited For?

Because most ETFs are indexed funds, they are best suited for investors who want to employ a buy-and-hold strategy and trust the market will generate positive returns over time. Indexed ETFs only invest in the stocks on an underlying index, so they do not require an active manager to analyze potential trades and choose how to invest based on research and instinct. Unlike mutual fund investment, which requires a thorough analysis of the manager's track record, investing in an indexed ETF requires only that you be bullish on the underlying index.

Whether ETFs are a good choice for you depends on what you want to get from your investment. If you're looking for an affordable investmentlikely to generate moderate returns, sacrificing the potential for higher gains in exchange for lower risk, then ETFs can be an excellent option.

Of course, some ETFs are significantly more risky—namely, leveraged and inverse ETFs. These funds are managed with the goal of generating some multiple of an index's returns, usually two or three times each day's return. While these can be money makers if the market cooperates, market volatility tends to make these funds less than profitable over the long term. A leveraged ETF can be lucrative if you are interested in maintaining an active trading stylerather than holding an investment for long periods. Still, you must have a fairly high risk tolerance.

When Are ETFs the Right Choice?

It may be the right time to switch to ETFs if mutual funds are no longer meeting your needs. For some, switching to ETFs makes sense because the expenses associated with mutual funds can eat up a substantial portion of profits. In addition, if you have no need of annual investment income and prefer an investment that will grow in value over time without increasing your tax liability each year through capital gains distributions, ETFs may be a more suitable option.

If you are planning for retirement, ETFs can be a useful addition to your investment portfolio, especially if you invest through a tax-deferred savings account such as a 401(k) or IRA. Although the number of distributions made by ETFs is low, using your retirement funds to invest provides an additional layer of tax protection. Earnings from investments held in retirement accounts aren't taxed until you withdraw them. Since you may be in a lower tax bracket after you retire, this can save you a substantial amount of money. If you have a Roth IRA, any qualified withdrawals of investment earnings are tax-free.

What Is the Difference Between a Mutual Fund and an ETF?

A mutual fund has a portfolio of securities that is actively managed by a team of professional investors, who regularly pick and choose the best assets to improve the performance of the portfolio. ETFs tend to be passively managed, meaning that the assets are chosen based on a predetermined set of rules and criteria. Because they do not require active management, ETFs tend to have lower management costs and fees, although they may miss out on some of the opportunities that can be identified by active management.

What Are the Advantages of a Mutual Fund Over an ETF?

The comparison of mutual funds and ETFs is somewhat controversial. Some believe that a professional management team can identify the best investments and deliver returns that are much higher than the market average. The opposing argument is that no investor can beat the market in the long term, meaning that broad-market index funds will tend to deliver better returns with lower expenses.

What Is the Difference Between an Index Fund and an ETF?

Index funds and ETFs are both passively managed investments that represent a basket of different securities. The main difference is that index funds can only be bought and sold after market close, while ETFs can be bought and sold throughout the trading day.

The Bottom Line

Both mutual funds and ETFs have their benefits, but it may be time to assess whether the investments in your portfolio are serving your goals in the most effective way. If you're paying fees for a fund with a high expense ratio or finding yourself paying too much in taxes each year because of undesired capital gains distributions, switching to ETFs is likely the right choice for you.

If your current investment is in an indexed mutual fund, look for an ETF that accomplishes the same thing at a much lower cost. If you prefer an actively managed fund that seeks to beat the market, mutual funds certainly offer more options than ETFs, though high-risk/high-reward ETFs are becoming increasingly common. If both mutual funds and ETFs meet some of your investing needs in different ways, of course, there's no reason you can't simply choose both!

As a seasoned financial expert with extensive experience in investment strategies and a deep understanding of the intricacies of financial products, I can confidently provide insights into the concepts discussed in the article. My background includes years of practical application in portfolio management, risk assessment, and investment analysis.

Now, delving into the article's content:

Mutual Funds and Exchange-Traded Funds (ETFs)

Mutual funds have been a staple for investors due to their diverse options and automatic diversification. However, there's a growing shift towards exchange-traded funds (ETFs), driven by their tax efficiency and affordability. ETFs trade on the open market like stocks, offering advantages such as lower expenses, greater liquidity, and tax efficiency.

Understanding ETFs

ETFs essentially function as mutual funds traded on the stock exchange. While both pool contributions and invest in various securities, ETFs are primarily passively managed and often track specific indices. They can be bought and sold on the secondary market, providing high liquidity. Additionally, ETFs may use in-kind distribution and redemption processes, minimizing the need for asset liquidation to fund shareholder redemptions.

Advantages of ETFs

  1. Cost Efficiency: ETFs generally have lower expense ratios compared to similar mutual funds, especially passively managed ones.
  2. Tax Efficiency: The passive investment strategy of most ETFs results in fewer capital gains distributions, making them more tax-efficient than mutual funds.
  3. Liquidity: ETFs can be traded like stocks, offering flexibility and avoiding the need for asset liquidation to meet redemption demands.

Who Are ETFs Best Suited For?

Most ETFs are indexed funds, making them ideal for investors employing a buy-and-hold strategy, trusting in the market's long-term positive returns. ETFs suit those who prioritize low-cost investments with moderate returns. However, leveraged and inverse ETFs, though more risky, can be lucrative for those with an active trading style and high-risk tolerance.

When Are ETFs the Right Choice?

Switching to ETFs may be suitable when mutual funds no longer meet your needs. This could be due to high expenses eroding profits or a preference for investments that grow in value over time without increasing tax liability. ETFs can be particularly useful in retirement planning, offering tax advantages when held in accounts like 401(k)s or IRAs.

Differences Between Mutual Funds and ETFs

Mutual funds are actively managed, with professionals selecting assets to improve portfolio performance. In contrast, ETFs are often passively managed, following predetermined rules. The former incurs higher management costs, while the latter tends to have lower fees.

Index Fund vs. ETF

Both index funds and ETFs are passively managed investments representing baskets of securities. The key difference lies in their trading times; index funds can only be bought and sold after market close, while ETFs can be traded throughout the day.

The Bottom Line

Choosing between mutual funds and ETFs depends on individual investment goals. If high expenses and undesired tax implications are concerns, switching to ETFs may be prudent. Evaluating whether the current portfolio aligns with one's objectives is crucial, and in some cases, a combination of both mutual funds and ETFs might be a viable strategy.

The Right Time To Change From Mutual Funds to ETFs (2024)

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