Mutual Funds Vs. ETFs - Which One Should You Use??
In this "Finance Friday" video, Andy Stolz, CFA, discusses the difference between using Mutual Funds or ETF's in your investment portfolio.
Tax-efficient investing has the potential to make a significant impact on your total wealth level when utilized correctly.
As always, feel free to reach out if you have any questions. If you'd like a portfolio review to look for additional opportunities as it relates to your specific situation, let us know!
Happy Friday! Have a great weekend!
This presentation may not be construed as investment, tax or legal advice and does not give investment recommendations. Any opinion included in this report constitutes our judgment as of the date of this report and is subject to change without notice.
Video Transcript...
Well, happy Friday! Hope you're doing well. Today, we're talking about the differences between ETFs and mutual funds. Who needs them? Why do we need them? Mainly, we're talking about the tax efficiency of the vehicle type we're using to implement our investment strategy. So, let's just jump into it.
ETFs versus mutual funds. For starters, just to give a bit of a backdrop here, ETFs are becoming much more common. You can get more strategies now through ETFs than you historically used to be able to.
If you look at net flows from mutual funds and ETFs, it's very clear that there's negative flows from mutual funds over the last decade or so, and positive flows into ETFs. So the question is, why is that?
If we just start with, what is a mutual fund? What is an ETF? The main difference is, as an investor, if you invest in a mutual fund, you are invested in that fund with other investors. Now, there's a whole bunch you can say about this, but for starters, you can be impacted by the actions of the other investors in a mutual fund. This is not true really with ETFs, for the most part.
So with a mutual fund, every December, you know, you get a list and they'll say, "Hey, here's the distributions the funds are going to be making." They'll make some type of distribution in December of capital gains. Now, you might not have sold or done any transactions in that mutual fund, but you may have realized capital gains that you'll have to pay tax on because of what the fund did.
I was looking at a Russell Investments study the other day, and they found that on average, US large-cap funds distributed about 9% (in 2021). So 9% of the fund being distributed, that's a pretty significant distribution amount. If it's all long-term and you are paying 15%, you're giving up something like 1.35% or so of your total return to taxes. I'm going to get into the numbers in just a second, but I want to compare and contrast that with an ETF.
When you buy an ETF, that ETF share is basically created just for you. So you don't have to have the impact of what the other investors in the fund are doing because there aren't really other investors in the fund. So most ETFs are able to operate without making any, or certainly, without making significant capital gains distributions. So that's the main difference between mutual funds and ETFs from a logistics standpoint.
So let's take a look at the numbers. I'm going to get to the lake, and then we'll take a look.
So, I used a 7% return, started with $1 million, and I assumed that 9% capital gains distribution and also 1.35% drag because 9% times 15% tax rate on long-term capital gains. Now, you might be in a higher long-term capital gains bracket. You might be in a 20% bracket, you might also have to pay the extra 3.8% on top of that, and then Washington now also has an income tax on long-term capital gains, so that would be another 7%. So theoretically you could pay up to 30% on your long-term capital gains. I used 15% for this assumption just to be fair and make it more inclusive to your average person.
So 10 years, $1 million, if you put it in an ETF that is not making any distributions, that $1 million grows to $1,967,000. If you did not use the ETF, you used a mutual fund that was paying a 9% distribution, taxable as long-term capital gains, that grew to 1,732,000. You can see a pretty significant difference there, $234,000 or so – an extra $23,000 a year, which is, on average, a couple percent – Pretty significant.
To be fair, you should adjust these for after tax. So I’ll include those numbers here. But, the point is that you don't have an annual tax drag on the portfolio if it's not making distributions like a mutual fund would. And that annual drag compounds over time too, so the more time you add, the more benefit you find from the ETF that doesn't make the distributions compared to the mutual fund that does. I hope that helps.
We've talked about a couple tax efficient investment strategies now, we've talked about asset location. Feel free to go watch that video if you'd like. This one we're talking about the actual structure or the wrapper of the investments that you use in a portfolio.
I would suggest you don't use an ETF if it doesn't fit your investment strategy. So, we've only over the last handful of years been able to have ETFs that closely mapped to the investment strategy that we like to use for our clients. So this is a transition we've made here just over the last several years. And frankly for clients we've had for a long time that have a lot of embedded gains in their portfolios, this takes longer to do. But there is a very clear benefit to an ETF in a portfolio over a mutual fund, using those average numbers anyway.
So feel free to reach out if you have any questions, and we'll talk to you soon. Have a great week!