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ETF 101: 5 Reasons ETFs Trump Mutual Funds

17 July 2007 at 9:46 am by Gary Gordon     Bookmark and Share    Follow EtfExpert on Twitter

I recently spoke at a seminar in New Orleans. Inevitably, the attendees wanted to know why ETFs are better than mutual funds. After all, don’t all 401ks have mutual funds in them? And how come most advisors keep insisting that exchanged-traded funds are for unsuccessful market-timers?

Having spent nearly a decade discussing the virtues of ETFs, I am often troubled by these inquiries. I know that advisors resist ETFs because they’re either lazy, uninformed or… worst yet… choosing to sell commission-based mutual funds. (And yes… that is why many advisors don’t like to talk about no-commission ETFs. Your advisor won’t make money on you!)

As for 401ks, they are mostly controlled by the biggest fund families and largest insurance companies. Since they themselves are not ETF providers, they are less likely to offer them in a plan that they are helping a company administer. (Yet, even 401ks are evolving. More 401ks have begun offering employees ETFs as an alternative within their plans each day.)

By way of review, here are 5 reasons that investors should look to exchange-traded funds for investment success, rather than traditional mutual funds:

1. ETFs Cost Less. Even though you do not receive a bill from mutual fund providers, you are charged a fee through the expense ratio. This is the primary way in which your fund family makes money. The typical mutual fund will run you 1.4%, or $1400 on every $100,000 that you invest. The average ETF has been estimated at approximately 0.36%. Even rounding up to 0.4%… $400 on every $100,000 invested is a lot less expensive than $1400.

2. ETFs Track Indexes… And Indexing Beats Actively Managed Mutual Funds. It may represent Wall Street’s dirtiest secret, but fund managers do not beat pre-established indexes over significant lengths of time. Over any 10-year period studied, the overwhelming majority of actively managed mutual funds with overcompensated stock-picking gurus cannot keep up with the benchmarks (a.k.a. indexes) that they are paid to beat. When a few managers do outperform, the stock picker has often taken excessive risks in one segment of the economy (e.g., technology, energy, etc.). Yet given time, those big risks come back to bite. In short, ETFs track indexes, and indexing are your preferred road to success.

3. Pricing. traditional mutual funds are priced at the end of the day. you have no control over the price you purchase at and, more importantly the price you may wish to sell at. In contrast, like individual stocks, ETFs makes it possible for you to choose the price point you wish to buy at. And, should you need to sell to protect your portfolio from sharp downturns, you have control over the price you wish to sell at as well.

4. Tax Efficiency. Traditional mutual funds buy and sell stocks. And many active managers have turnover rates… rates of turning over a portfolio in a year… of 100%. That’s a lot of buying and selling of stock picks. The mutual fund structure. passes along capital gains form the buying and selling activity to the fund shareholder. You may not have any personal gains from being a fund shareholder, but come year-end, you are likely to experience a distribution that you must pay tax on… even when you are simply holding the fund! ETFs have next-to-no turnover because indexes rarely change. The low turnover of ETFs leads limit capital gains distributions and, due to a unique structure for ETFs, even rebalanced indexes do not necessarily have to buy and sell. In short, if you wish to keep the money you make, rather than pay taxes, ETFs win hands down!

5. Transparency. When you buy a mutual fund, what do you really know about it? You see a few stars from a rating group like Morningstar. You see a number of calendar year percentage gains. Do you really know what the fund manager invests in? You may get as description of the top 10 holdings in  a previous 3 month period, but you are essentially, guessing. In contrast, an exchange-traded fund (ETF) represents a specific index. You know exactly the stocks in that index and exactly the weight of each stock in the index. That transparency gives you the confidence to know what you are investing in… precisely.

Disclosure Statement:  As a Registered Investment Advisor, Pacific Park Financial, Inc. may hold positions in the ETFs, mutual funds and/or index funds mentioned above.

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