When it comes to investing in a bond fund, there are two primary options available: mutual funds and exchange-traded funds (ETFs). Both offer investors a way to pool their resources together with other like-minded individuals in order to achieve a common investment goal. However, that’s where the similarities end. ETFs are a newer type of investment vehicle that have a number of advantages over traditional mutual funds. Here’s a look at three reasons why you should consider investing in an ETF instead of a mutual fund.
Benefits of a Bond ETF over a Bond Mutual Fund
1. Lower Expenses
One of the biggest advantages of ETFs over mutual funds is that they tend to have much lower expense ratios. An expense ratio is the percentage of assets that a fund manager charges each year to cover the costs of running the fund. This includes fees for things like research, administration, and marketing. ETFs typically have expense ratios that are just a fraction of what you would pay for a comparable mutual fund. For example, the average expense ratio for an ETF is 0.44%, while the average expense ratio for a mutual fund is 1.19%.2 That might not sound like much, but over time, those lower expenses can add up to significant savings. For example, if you had $10,000 invested in an ETF with an expense ratio of 0.44% and earned an annual return of 7%, after 20 years you would have $49,675. If you had invested that same $10,000 in a mutual fund with an expense ratio of 1.19% and earned the same 7% annual return, after 20 years you would only have $40,977—nearly $9,700 less.
2. Tax Efficiency
Another advantage of ETFs over mutual funds is that they tend to be more tax efficient. This is because mutual funds are required by law to distribute their capital gains to shareholders at least once per year, even if those shareholders reinvest their distributions back into the fund. This can create problems come tax time because investors may be subject to taxes on capital gains even if they haven’t sold any shares of the fund. ETFs don’t have this requirement because they trade on exchanges like stocks—so they’re not subject to the same rules as mutual funds when it comes to distributing capital gains.5 As a result, investors in ETFs may be able to defer taxes on their capital gains for years or even decades—something that’s not possible with most mutual funds.
3. Greater flexibility
Lastly, ETFs offer investors greater flexibility than mutual funds when it comes to things like short selling and trading on margin. Short selling is when an investor borrows shares of an asset from another party with the hope of selling it at a higher price and then repurchasing it at a lower price so they can return it to the original owner and pocket the difference as profit. Trading on margin refers to using borrowed money from a broker in order to purchase securities—it essentially allows investors to leverage their existing capital in order to potentially generate larger profits (but also larger losses). Because ETFs trade on exchanges like stocks, investors can do both of these things with relative ease—something that’s much more difficult (and sometimes impossible) with mutual funds.
Investors who are looking for a lower-cost, more tax-efficient way to invest in a basket of assets should consider exchange-traded funds (ETFs) instead of traditional mutual funds. While both types of investment vehicles offer investors a way to pool their resources together with other like-minded individuals in order achieve a common investment goal, ETFs have several advantages over mutual funds—including lower expenses, greater tax efficiency, and more flexibility when it comes to things like short selling and trading on margin.
See:1. what is an bond exchange-traded fund (etf)?.