Previously, we reviewed the potential advantage of exchange traded funds (ETFs) over mutual funds relating to enhanced trading flexibility and annual expense ratios.
We will now look at advantages (or not) of ETFs in respect of transaction costs and tax efficiency. The benefits of ETFs over mutual funds (or not) will be a function of how investors set up their accounts and implement investment strategies.
Transaction Costs
Loads
ETFs trade like stocks. There are no sales charges (i.e., loads) charged by the issuing fund company.
Conversely, open-end mutual funds may be subject to sales charges. Given the number of funds available, I seldom recommend anyone pay a load for an index fund. But be aware that they do exist and be careful about paying any loads.
If you avoid funds with sales charges, there should be no cost difference between an ETF and an open-end mutual fund in this aspect.
Broker’s Commissions
Although there are no loads for ETFs, all trades are subject to broker’s commissions when ETFs are bought or sold.
If you buy or sell open-end funds directly through the fund company, you will not pay a commission. You are also normally able to transfer capital between funds of the same family without charge. So, open-end funds might actually be cheaper to trade than ETFs.
In buying and redeeming funds directly through the fund company, transaction costs may be cheaper for funds than ETFs.
However, for convenience, many investors hold all their portfolio investments in one or two brokerage accounts.
If you use your brokerage account to trade open-end funds, you may be charged a broker’s commission similar to what is charged on an ETF. Every broker has a different pricing scheme. Review their commissions on ETFs and mutual funds.
Also, many brokers have arrangements with certain fund companies so that commissions on some open-end funds are waived. That may also impact your costs and investment decisions.
Tax Efficiency
Another potential advantage of ETFs over open-end mutual funds is their tax efficiency.
It is often cited that taxable capital gains are only incurred when the investor sells an ETF. With mutual funds, the capital gains flow out to shareholders as the fund itself incurs gains on internal sales. As a result, shareholders may be liable for capital gains taxes even while they still own the mutual fund shares.
Of course, the relevancy of this advantage depends on the your own tax laws. I suggest you take a look at the jurisdiction applicable to you and determine what, if any, advantages ETFs may have over mutual funds in respect of taxes.
Given that taxes can significantly impact your wealth accumulation over time, always a good idea to focus on tax efficiency. This is an area where a competent financial advisor with tax knowledge is often worth the expense.
Conclusion
After all that it remains to be seen if ETFs truly provide cost advantages against major open-end index mutual funds in the same category. This runs contrary to conventional wisdom on the subject. Something I suspect arose back when fund costs were significantly higher.
Do not blindly assume that ETFs will be cheaper than all open-end index mutual funds.
Always compare costs before investing in one or the other.
Factor in how you intend to trade (e.g., via fund company versus broker, frequent trades versus buy-and-hold, etc.). That will impact your decision and costs.
Finally, never forget taxes. They have enormous impact on long term investing success.
