Mutual Funds and ETFs: Same Holdings, Different Wrappers

The same index can be bought in two wrappers: a traditional mutual fund or an exchange-traded fund (ETF). The holdings can be identical and the fee nearly the same, yet one can hand you a tax bill in a year you sold nothing, and the other can tempt you into trading you would never have done otherwise. This chapter explains how each wrapper works, where the real differences show up, and how to choose by account and by habit rather than by fashion.

How the two wrappers work

A mutual fund sells shares directly to you and buys them back from you. Orders placed during the day are all filled once, at the net asset value (NAV) calculated after the market closes: the value of everything the fund owns, divided by the shares outstanding. You can invest an exact dollar amount, and the fund issues fractional shares to match. When more investors sell than buy, the fund has to raise cash, usually by selling some of its holdings.

An ETF is bought and sold on a stock exchange, from other investors, at whatever price the market sets during the trading day. Behind the scenes, large dealers called authorized participants create new ETF shares by handing the fund a basket of the securities it holds, and redeem shares by taking a basket back. Because those swaps are made in securities rather than cash, the ETF rarely has to sell holdings to meet redemptions. The ETF's market price normally stays very close to the value of its holdings, because dealers profit from closing any gap.

That one structural difference, cash redemptions versus in-kind swaps, drives most of what follows.

Costs beyond the expense ratio

For broad index funds, expense ratios in the two wrappers are often similar, and many fund companies offer the same index both ways. The other costs differ.

• Bid-ask spread. Every ETF trade happens between the price buyers are offering and the price sellers are asking. For large, heavily traded ETFs the gap is tiny; for small or specialised ones it can be wide enough to matter, especially if you trade often. A limit order sets the most you will pay.
• Premiums and discounts. In fast markets an ETF's price can move a little above or below the value of its holdings. Mutual funds always trade at NAV.
• Minimums. Some mutual funds require a minimum first purchase; an ETF requires one share, or less where your broker offers fractional shares.
• Commissions and transaction fees. Most large brokers no longer charge commissions on ETF trades, but some charge a fee to buy another company's mutual funds. Check your own broker's schedule.

Taxes: where the wrappers really differ

Inside a 401(k), IRA or other tax-advantaged account, none of this section applies: trades and distributions inside the account are not taxed each year. In a taxable brokerage account, it can matter a great deal.

When a mutual fund sells holdings at a gain, whether to rebalance, to follow its index or to pay departing shareholders, the law requires it to pass the net gains to everyone who owns shares that year as a capital gains distribution. You owe tax on it even if you reinvested it, and even if you bought the fund weeks before the payout. Distributions reported as capital gain distributions are taxed as long-term gains no matter how long you have held the fund (IRS Publication 550). Actively managed funds that trade a lot, and funds that lose many shareholders, tend to distribute the most.

Most ETFs distribute few or no capital gains, because the in-kind swaps let them hand their lowest-cost shares to departing dealers instead of selling them. You still owe tax on dividends each year, and you owe tax on your own gain when you sell. The difference is that you choose when.

One way to see what that is worth is to treat the yearly tax on distributions like an extra fee. Suppose a fund pays out gains equal to 2% of its value each year, taxed at the 15% long-term rate that applies to most investors. That costs about 0.3 percentage points a year.

Left alone for 20 years at 7.0% a year, $50,000 grows to about $193,484 if no tax is paid along the way, and about $182,919 if 0.3% a year goes to tax on distributions, a difference of $10,565. This is a simplification: the ETF holder still owes tax on the gain when they sell, but later, possibly in a year with a lower rate, and gains held until death may escape income tax entirely under current law. Deferring a tax is worth something even when the tax is eventually paid.

Two practical points follow. Before buying a mutual fund in a taxable account late in the year, check the fund company's estimate of upcoming distributions, and consider waiting until after the payout date. And before selling a fund you already own to switch wrappers, compare the tax on your own gain with the yearly drag you would save.

Trading flexibility cuts both ways

Intraday trading helps when you need it: putting a large sum to work at a known price, selling a specific lot to harvest a loss, or rebalancing several funds in the same hour. It hurts when it turns a long-term holding into something you check and trade. Brad Barber and Terrance Odean's study of individual brokerage accounts, published in 2000, found that the households that traded most earned noticeably less than those that traded least, mainly through costs. A mutual fund's once-a-day price is a small speed bump that some investors find useful.

Automatic investing has traditionally been easier with mutual funds, since you can invest an exact amount on a schedule. Many brokers now offer automatic purchases of ETFs in fractional shares, which narrows that difference.

Choosing by account and by habit

A simple way to decide:

• 401(k), 403(b) or similar plan. You usually have no choice of wrapper; most plans offer mutual funds or collective trusts. Choose by cost and by what the fund holds.
• IRA or Roth IRA. Taxes on distributions do not apply, so choose whichever is cheaper and easier to automate at your broker.
• Taxable account, buy and hold. The ETF's tax efficiency usually decides it for broad stock funds. Index mutual funds with low turnover can also be fairly tax-efficient, so check a fund's history of distributions rather than assuming.
• Regular small contributions. A mutual fund, or an ETF at a broker that supports automatic fractional purchases.
• Narrow or specialised exposure. The choice is mostly among ETFs, which also means checking the spread and the fund's size.

Whichever wrapper you use, the fund's holdings and its total cost matter more than the wrapper. A cheap, broad mutual fund beats an expensive, narrow ETF.