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Five Advantages of ETFs vs. Mutual Funds

by Michael Johnston on June 1, 2009

It’s frequently written in the financial presses that ETFs are now challenging traditional actively-managed mutual funds for investor dollars. While mutual funds are still the dominant player in the industry, ETFs have made significant inroads in recent years, due in large part to several significant advantages over mutual funds.

Lower Expenses: This is the easy one. ETFs have become so popular in recent years because they don’t even attempt to accomplish what mutual funds have repeatedly failed to do: beat the market (although there are some actively-managed ETFs on the market now that do strive to deliver excess returns). Since most ETFs replicate an underlying index, they don’t incur trading fees and commissions on a regular basis. Moreover, ETFs don’t employ teams of analysts tasked with finding superior stocks. And this means increased savings for ETF investors. Whereas the average mutual fund charges fees of 1.4% (according to Morningstar), ETF expense ratios can be as low as 0.10% (a number of Vanguard funds check in at this rate).
Tax efficiency: Many new to ETFs get the wrong idea when they hear that these funds offer greater tax efficiency relative to mutual funds. ETFs don’t eliminate your tax obligations, they simply delay them. Because of the way they are created and redeemed, ETF investors are able to delay incurring capital gains as the fund sells shares. Mutual funds, on the other hand, incur taxes with much greater frequency, due to increased trading activity and the regulatory structure. For a quantitative example of the tax efficiency of ETFs, consider the results of this recent study.
Daily disclosure: Unlike mutual funds, which are required to disclose their holdings only four times per year, ETFs are required to release holdings data on a daily basis. Although this may not seem like a significant advantage, it can be be important in certain situations. For example, let’s assume that a major U.S. investment bank has just announced that it is no longer solvent and is expected to be wound down and sold for pennies on the dollar (sound familiar?). Mutual fund investors would have difficulty uncovering their level of exposure to the distressed company, since quarterly disclosure filings may be drastically out of date by that point. ETF investors, on the other hand, would have immediate access to any ETF’s holdings as of the close of trading on the previous day. Here’s an example of daily disclosure reports for iShares Dow Jones Select Dividend Fund (DVY)
Increased Flexibility: Unlike mutual funds, ETFs can be shorted if investors anticipate a downward movement in a particular index or commodity (note that there are now a number of invese ETFs on the market that offer a short position by going long on the fund). While short selling is a risky strategy, it is a useful tool for experienced and sophisticated investors that can lead to significant profits if the market becomes overvalued (as anyone who has sold almost any equity index short in the last year can attest).
Intraday trading: While traditional mutual funds can only be redeemed at the end of the day, ETFs trade throughout the day, similar to common stocks. Although ETFs are often used as part of a buy-and-hold investment strategy, meaning that immediacy of trades is not a major concern, there are certain occasions when time will be of the essence. In such situations, ETF investors will be able to execute a trade immediately, while mutual fund investors will be left waiting.

Tip of the Iceberg

These are only a few of the advantages of ETFs over mutual funds. If you’re interested in reading more on the basics of ETF investing, check out the ETFdb Library, or one of these additional resources: