The benefits of ETFs over traditional investment vehicles like stocks and mutual funds have not gone unnoticed by investors and advisers alike. With inflows into ETFs exploding annually while hedge funds and other actively managed funds were brought back to earth during the financial meltdown, it’s worth considering just what makes ETFs so much better than mutual funds and stock-picking.
Lower Expenses - Perhaps first and foremost, ETFs are generally the most cost-efficient means of investing. Since the goal of the vast majority of retail investors is buy and hold, it makes no sense whatsoever to buy and hold a similarly performing (or worse) actively managed mutual fund over a long period of time when a suitable lower cost option exists in an index ETF.
Using one of the top index ETFs with an expense ratio as long as 0.10% yields enormous benefits in terms of total return over a prolonged period of time. consider a mutual fund with 12b-1 fees and an expense ratio of .75% to 1.5%. In some cases, investors need to pay an up-front or back-end load of 3-5.5% to boot! Data indicates that the majority of actively managed mutual funds do not beat their target index. As such, in lieu of a mutual fund manager’s ability to overcome these cost differential with performance (extremely rare), there is no justification for investing in actively managed mutual funds.
The case against individual stock picking is even stronger. At least a mutual fund provides for the diversification of a broad portfolio of stocks. In the case of individual stockpicking, an investor is confronted with commissions and fees associated with multiple stocks, dividend inflows, dealing with splits, acquisitions, spinoffs, etc. Very few investors have the discipline to buy and hold stocks to the same degree they do so with index ETFs or mutual funds either. While some investors may choose to stock-pick successfully like say, buying Apple shares or Netflix shares early on in an uptrend, trying to replicate a broad index of 50 or more stocks individually is not practical.
Ability to Trade Real Time - In contrast to the notion above of buying and holding, in the event of personal need or an extreme market situation, an ETF can be bought or sold instantaneously just like a stock, whereas a mutual fund is often not executed for the next day or two based on the price at close of trading. This is a pretty severe restraint, especially for those looking to exit the market during the financial collapse of 2008-2009.
Infinite Possibilities with Niche and Specialty ETFs – While mutual funds tend to be broadly focused or have a particular investment theme based on the fund manager or sponsor company, hundreds of new ETFs are being launched annually which focus on very specific niches. For instance, some high performing ETFs you probably never heard of include this Preferred Stock ETF and this Spinoff ETF, each of which have killed the market recently. With ETFs coming to market based on quant theory, leveraging (see the incredible results of shorting leveraged ETFs in pairs) and other alternative strategies, the opportunities are limitless.
Better Tax Treatment – Since ETFs are generally holding index or pre-designated stocks for a long period of time as opposed to actively managed mutual funds which react to the whims of market trends and media hype, the tax implications are often muted considerably for ETFs vs Mutual Funds. This benefit adds up over time just like lower expense ratios. Often times, fund managers feel compelled to rush into the hot stocks at the close of a quarter so they show it as a holding in the prospectus or they have to sell a high flyer with a huge capital gain on the books to free up cash for redemptions when outflows begin. These moves subject the mutual fund owner to much more significant tax liabilities than a similarly themed ETF. Individual stock picking carries a similar profile to mutual funds in that the turnover is generally much higher due to investor behavior.
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