I’ve already written about Why ETFs Beat Individual Stocks but did you know ETFs also beat mutual funds? Though Exchange Traded Funds (ETFs) and mutual funds both allow investors to own a group of investments by making just one purchase, ETFs have several distinct advantages over mutual funds:
ETFs vs mutual funds
- ETFs have Low Minimum Investment and Trading Flexibility
- ETFs typically have lower Expense Ratios
- ETFs offer trading flexibility
- ETFs also offer some tax advantages
- ETFs offer protection against possible fraud
- ETFs have opportunities for options and short selling
ETFs offer tax advantages
Mutual funds incur a tax liability whenever their investments generate income or capital gains (profits from sales). Mutual fund shareholders pick up the tab for these taxes, which explains why an actively managed fund’s after-tax return is often several percentage points less than its pretax return.
ETFs have two advantages over mutual funds when it comes to taxes:
Lower taxes than actively managed funds
Turnover is the frequency with which a fund sells its investments. A high turnover rate often results in high tax bills, since capital gains on investments held for less than one year are taxed at higher rates than investments held for a year or more. Since the underlying indexes that ETFs and index funds track rarely change, ETFs and index funds seldom sell the investments they track, and therefore they incur minimal tax liabilities. Actively managed funds, though, often have high turnover, which can generate sizable tax bills.
Deferred tax bills
Mutual fund investors must pay taxes on their funds’ income or gains before they even sell the fund — for example, if you hold a mutual fund for 10 years, you’ll likely pay taxes on your earnings from that fund each year. ETFs let you defer paying taxes entirely until you sell. Deferring taxes lets you keep more of your money invested and growing, which can boost returns over time.
How to buy ETFs
You’ll have to open an account at a brokerage company. Click the links below to get further information:
- Scottrade – you can buy Focus Morningstar ETFs commission free!
- Etrade – E*Trade helps you get started investing in three easy steps
- TradeKing – offers regular trades and broker assisted trades for only $4.95
- tradeMonster – offers mobile trading
- Zecco – has commission free trades available
- ShareBuilder – invest for only $4 on an automatic investment plan