We generally prefer to use exchange traded funds (ETFs), but there are still certain circumstances in which mutual funds are a better choice for our customer accounts. First, let’s talk about the plusses of exchange traded funds, index funds in particular:
1. Because exchanged traded funds are stocks and trade on an exchange, they can be purchased or sold with limit orders during the day, at known prices, rather than executed after hours at a net asset value to be determined as you with a mutual fund(open ended fund).
2. The ETF fund’s holdings are in nearly all cases transparent daily. Mutual Funds release their holdings only quarterly, so you are always looking backward for as long as three months.
3. The creation/redemption mechanism and low turnover of index ETFs allows an investor freedom from unexpected capital gains distributions. Because the manager does not have to sell underlying portfolio holdings to raise cash for redemptions, the cash raising takes place at the investor level, allowing for a high degree of personal control over tax liability.
4. If the most attractively priced mutual fund share class is not available to the investor through his/her brokerage firm, it is likely that an equivalent ETF will have the lowest embedded management fees available, leading to improved long term performance.
Mutual Funds continue to work better for our clients in certain cases, because they do trade at daily Net Asset Value (NAV), and because additional purchases and dividend reinvestments are free from transaction fees.
1. Whenever there are relatively illiquid underlying investments in a fund, an ETF can trade at a premium or discount from the price of the holdings, particularly since the NAV is set at prior day’s market close, and is therefore “stale”. Take the NAV of a municipal bond portfolio for example. Its component bonds might rarely trade, so the NAV might be based in part on price estimates. The equivalent ETF might trade at a higher or lower price than the NAV, reflecting fast moving intraday opinion about where the municipal bond portfolio should be trading or other real-time market dynamics. That premium or discount element can persist for long periods, particularly in steadily progressing or steadily retreating market, leading to underperformance of your ETF investment return.
2. If a client is making regular contributions to his/her account, multiple ETF purchases would incur multiple trading commissions. Additional mutual fund purchases would not incur such transaction costs. (Exception: some brokerage firms waive commissions if you are buying their proprietary label ETFs)
3. If an investor is eligible for the most attractively priced mutual fund share class through the broker dealer, often by investing a minimum amount, the embedded management fees might be lower than an equivalent ETF, leading to improved investment performance.