On the other hand, mutual funds may impose restrictions and/or penalties on short-term traders to discourage speculative moves.
Instead, those with a longer investment horizon are more concerned about overall expense ratio. Most long-term investors have gravitated toward ETFs because of the fund’s cheaper fees. U.S.-listed passively managed ETFs have an average expense ratio of 0.55% and the cheapest ones come with a 0.04% fee, according to XTF data.
Moreover, long-term investors may enjoy ETFs for the more favorable tax consequences. When an investor sells a mutual fund, the active fund has to sell securities to raise cash, which triggers a taxable event and issues capital gains for all investors. ETFs, on the other hand, employ a type of “in-kind” transaction where ETF shares are swapped for baskets of underlying securities, or vice versa, so no cash is involved and no taxable event is triggered. [How ETFs Are Traded]
However, ETFs are not completely immune to capital gain distributions. For instance, if an index is updated, the fund will have to do some buying and selling.
Baldwin argues that investors can disregard the tax efficiency if one is buying in a tax-sheltered account, but if you are buying in a taxable account, investors may be better off with ETFs.
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.