Several times a year, I hold an educational workshop called Taxes in Retirement. If you’re interested in attending our upcoming workshop click here. During the class, I mention the tax-efficiency of exchange-traded funds (ETFs) as compared to mutual funds in a non-qualified account.
Unfortunately, 7 out of the 21 attendees raise their hands with the same question: “What’s an ETF?”. Perhaps I shouldn’t take it for granted that everybody knows what an ETF is and how it differs from a mutual fund. Furthermore, there’s been a few developments in the world of ETFs that have my industry buzzing.
A Stock and a Mutual Fund have a Baby
So what is an ETF? It’s best to describe it by metaphor: the love child of a stock and a mutual fund. An ETF is an investment fund traded on a stock exchange. It’s like a mutual fund in that it holds stocks, bonds and/or commodities. Like a mutual fund, it provides a diversified basket of holdings with one ticker symbol. Like a mutual fund, there are many active and passive themes represented to further complicate things.
But the ETF has characteristics like a stock that make it different from a mutual fund. Most noticeably it can be traded during the day, like a stock, not just at the end of the day like a mutual fund. Also, when you redeem your shares of a mutual fund the holdings within the mutual fund must be sold. This can create a capital gains for others holding the mutual fund who did not redeem their shares. Not so with an ETF. When you want to sell your ETF, you just sell it on the market. The holdings inside were not affected and no tax was created for other people based on your sale. There may be taxes on an ETF based upon the index or active strategy rebalancing, but it’s far less an issue than in mutual funds.
Born in Canada in 1990, ETFs are young when compared to the reign of mutual funds beginning in 1924 AD. As of March 2019, domestic holdings of mutual funds are over 19 trillion and ETFs had over 3.7 trillion. Source But remember, ETFs are just teenagers compared to mutual funds. The key is how fast ETF are gathering new money compared to mutual funds. ETFs grew at an organic annualized rate of 19% from 2009 through 2017, easily outpacing the 4.8% growth rate for other open-end funds. Source: Investment Company Institute, ETFGI as of March 2018.
What is driving this transfer of power? Several things:
- A move towards indexing versus active stock-picking. Over 40% of investors are using passive index ETFs and mutual funds. This is a major shift from a generation ago when active mutual funds relied on stock pickers to outperform an index.
- ETFs have lower internal fees than active mutual funds and may have lower internal fees than some index mutual funds.
- The tax efficiency as mentioned above.
Long Live the King
Two recent developments will help promote the use of ETFs for the long term. First, the SEC has announced that they will adopt standardized rules for ETFs. Source Called Rule 6c-11, this will make it quicker and cheaper to issue new ETFs. It will also make transparency and disclosure rules more uniform. It reminds me of the VHS vs BetaMax days. Once there is an industry standard that industry can really blossom.
Second, active ETFs are gaining steam as well. In the past, active mutual fund managers preferred the privacy of only having quarterly holding disclosures. Traditional ETFs required daily disclosure of holdings. Source This kept active managers away from ETFs because they didn’t want everybody knowing their secret sauce. Recently, active ETFs have been structured to hide their holdings for a quarter just like mutual funds. However, they’ll pass along much of the benefits of ETFs. This portends a long reign for the ETF if both passive and active strategies can flourish.
The bottom line is that exchange-traded funds are here to stay and it would be worth some time to understand them. More importantly, ask yourself if they make sense in your portfolio. If you’d like a second opinion on yours, click here.
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