by Andrew Sivertsen, CFP® CeFT®
Exchange Traded Funds (ETFs) were developed in the late 90s but have grown in popularity over the last decade since the great recession. An ETF, just like a mutual fund, is a wrapper for investing that bundles a number of stocks and bonds together into one diversified investment. The primary difference is simply how they are traded. Mutual fund shares are bought or redeemed at the end of the trading day for whatever the value of the underlying investments are worth at that time, whereas ETFs trade live on markets and the price will vary based on the time of day that you place the trade.
Which are better?
The answer to that question is not as simple as you would think. There are several details and factors to consider when you decide whether to invest in mutual funds or ETFs. Once a vehicle is picked, there are additional considerations to ensure best execution in trading practices. That is where TPC is here to help.
What about cost?
Until recently, ETFs have only been able to be offered as passive index funds. An index seeks to match the performance of a particular market or asset class by investing in all the stocks/bonds in that index. Index funds are typically very low in cost. For instance, the average cost of a mutual fund is roughly 1.25% whereas the average ETF is roughly 0.25%. By lowering the internal cost, this can keep more of the total return in the shareholder’s account. At The Planning Center, we have always been sensitive to cost and tried to eliminate any expenses that we don’t believe add value. The mutual funds that we have used from Dimensional Fund Advisors (DFA) and Vanguard have typically created a low-cost portfolio that is similar in cost to the average ETF.
What about taxes?
For non-qualified after-tax accounts (i.e., individual, joint, trusts, and corporate accounts) extra care must be taken when investing in mutual funds and ETFs to be conscious of strategic decisions regarding dividends, interest, and capital gains, which can affect your current and future year taxes. In the eyes of the IRS, both ETFs and mutual funds are treated the same for the most part. On average, ETFs have historically been more tax efficient due to efficiencies created in the redemption process. This is something The Planning Center has been aware of and monitored over the years. DFA has tax-managed mutual funds that have historically been able to offer competitive tax efficiency to the average ETF market.
Anything else I should be aware of?
Recent legislation has allowed investment companies like DFA to move into the ETF space without using index funds. DFA saw this as an opportunity to convert their tax-managed funds into ETFs to hopefully enhance their tax efficiency. In June of 2021, we will see most of DFA’s tax-managed mutual funds convert to ETFs with the intent of converting the rest of their U.S. and International tax-managed funds later in the year. As a result, we may see more ETF strategies that make sense for our clients in the coming years.
Will this affect my distributions?
ETFs and mutual funds have different settlement dates when sold to cash. Sales of mutual funds settle into cash on the next day whereas ETFs take two days to settle into cash. For client’s that have regular monthly distributions, this will not impact your automatic distributions. However, for those who call in for periodic distributions, this can add a day to get cash into your bank account. Please try and keep your planner appraised of upcoming distribution needs and allow 5 business days to safely process one-time distributions.
There are several other factors and differences regarding both mutual funds and ETFs and we plan to continue sharing this information with our clients. Please know that we are here for you. If you have questions, discuss them with your planner in your next meeting.
Andrew Sivertsen, CFP®, is a Sr. Financial Planner in the Quad Cities office of The Planning Center, a fee-only financial planning and wealth management firm. Email him at: andrew@theplanningcenter.com.
