Why Investors Prefer ETFs Over Mutual Funds
Over the past ten years, investors have withdrawn $1.4 trillion from stock mutual funds and added $2.9 trillion to ETFs (Exchange Traded Funds) according to Morningstar. Mutual funds and ETFs serve similar purposes like diversification, professional management, liquidity, etc. Why have investors been fleeing stock mutual funds to ETFs?
First, the key differences between the two investment vehicles.
The idea behind a mutual fund is to allow investors, particularly smaller ones, to invest in a broad array of assets that would be difficult to manage on an individual basis due to the high minimum investment requirements or the need for extensive research and management. By investing in a wide range of assets, mutual funds help reduce the risk of loss from any single investment. Mutual funds are managed by professional fund managers who make investment decisions on behalf of investors. Shares of mutual funds can typically be bought or sold at the end of each trading day at the fund's current net asset value (NAV).
ETFs are similar to mutual funds in that they offer investors a way to pool their money in a fund that makes investments in stocks, bonds, or other assets and, in return, to receive an interest in that investment pool. However, unlike mutual funds, which are only traded at the end of the trading day at the net asset value (NAV) price, ETFs are traded throughout the trading day at market prices that can fluctuate throughout the day.
ETFs often have lower expense ratios compared to mutual funds due to their passive management structure. Many ETFs are designed to track a specific index, thereby minimizing the need for active management.
While both mutual funds and ETFs allow investors to pool money to invest in a diversified portfolio of securities, they differ in trading mechanics, costs, management styles, and tax implications.
ETFs are generally more tax-efficient than mutual funds due to their unique structure and the way transactions are executed. During times of financial stress, sell orders could exceed buy orders by a wide margin, exhausting cash reserves. Mutual funds must sell their assets to satisfy redemptions generating capital gains which are passed onto shareholders. However, ETFs do not have to sell their assets because the shares are traded at the stock exchanges. The supply and demand for an ETF share determine the share price, just like a share of Microsoft at the NYSE.
A minimum investment is another reason favoring ETFs. Mutual funds have minimum investment requirements ranging from a few hundred to several thousand dollars. For ETFs, the minimum investment is the price of one share since they are traded like stocks. More individual investors with limited funds can purchase ETFs.
The costs of running a mutual fund are generally higher due to active management and administrative costs. Mutual funds can also charge sales loads or commissions. ETFs are more commonly passively managed, though actively managed ETFs exist. The passive approach generally results in lower fees. Typically, ETFs have lower expense ratios, especially for index ETFs, since many are passively managed.
Investors have increasingly favored ETFs over mutual funds, driven by ETFs' lower costs, tax efficiencies, and flexibility in trading. This trend highlights the shifting landscape of investment preferences, largely due to ETFs' advantages in trading mechanics, expense ratios, and accessibility for individual investors with limited funds. Should you consider shifting your funds to ETFs?