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Are Exchange-Traded Funds Right for You? Costs and Taxes

Are Exchange-Traded Funds Right for You? Costs and Taxes

ETFs should appeal to cost-conscious investors who don’t trade frequently. Multiple Morningstar studies have shown that a fund’s expense ratio is a reliable predictor of the future success of an investment, and ETFs are often amongst the lowest cost options available. And because ETFs trade on exchanges, transactions occur directly between investors, meaning ETF providers don’t have to manage hundreds of customer accounts or staff call centers. This reduces ETF providers’ overhead and, by extension, expense ratios. In addition, ETF providers do not have to pay high salaries to active portfolio managers the way mutual fund firms do. On average, ETFs have a noticeable expense ratio advantage over the typical passive and actively managed mutual funds in many of Morningstar’s fund categories.

Consider trading costs

While ETFs’ low expenses are touted as one of their key benefits, the fact remains that investors who, like most people, regularly invest sums of money may actually end up paying more for an ETF than for most mutual funds.

Investors pay a brokerage commission each time they buy and sell an ETF, so their costs mount with each trade. Commissions can add up quickly, so if with periodic investments over time, investors’ overall costs could be lower with a no-load mutual fund.

Consider the tax advantages

ETFs may hold a special attraction for investors in taxable accounts. With a regular mutual fund, investor selling can force managers to sell stocks in order to meet redemptions, which can result in taxable capital-gains distributions being paid to shareholders. In contrast, most trading in ETFs takes place between shareholders, shielding the fund from any need to sell stocks to meet redemptions.