8 Ways ETFs Can Put More Money in Your Pocket Than Mutual Funds

By Tim Lemke on 2 April 2015 0 comments

One of the most common pieces of investment advice is to diversify your portfolio. This means having a good mix of investments, including stocks from a variety of asset classes and industries. Mutual funds have long been the most common way for investors to easily diversify their portfolios, but there's a relatively new investment vehicle that is arguably better.

Exchange-traded funds, or ETFs, have many advantages over mutual funds, and should be a part of most investment plans. ETFs are very much like mutual funds, in that they are designed to track a particular index, such as the S&P 500, or industries like health care or tech. But unlike mutual funds, they can be bought and sold just like stocks. (See also: The Top 5 ETFs You Should Buy Now)

There are now more than 1,000 ETFs available for most investors, and they are growing in popularity. Here's a look at some key advantages of ETFs over mutual funds.

1. Expense Ratios Are Lower

Generally speaking, you will keep more of your money if you trade an ETF over a mutual fund. Most ETFs have expense ratios of less than 1%, and there are some — such as the iShares Total Stock Market ETF [ITOT] — which have ratios of under 0.1%. (Disclosure: A significant portion of my Roth IRA is invested in this ETF.)

2. You Can Trade Many ETFs Without a Commission

Depending on the brokerage, you can buy or sell many ETFs at no charge. Fidelity, for example, charges no commission for iShares ETFs, and TD Ameritrade has more than 100 commission-free ETFs. This will save you a great deal of money, especially if you like the idea of buying small quantities of ETFs frequently.

3. They Trade All Day on the Exchange

Unlike mutual funds, ETFs are available for intraday trading. This means that you can buy them or sell them quickly if you believe the market may go up or down sharply during the day, and also place limit orders, which allow you to direct your broker to buy or sell only at a specific price.

4. You Can Take Short or Long Positions

Because ETFs trade like stocks, you can use them in options trades. This means you can potentially profit from a down market. For example, if you believe an ETF will lose value, you can "borrow" shares and then sell them at a higher price using the proceeds to buy them back at a lower price in the future. (Note: This investment activity is complex and generally for more experienced investors.)

5. They Offer Tax Advantages

ETFs are built to be tax efficient. They are generally passively managed, so they do not produce as much in the way of capital gains. ETF managers are also not required to sell shares — and thus produce capital gains — to accommodate the redemption of shares.

6. There Are No Minimums

It's possible to buy or sell just a single share of an ETF. Contrast this to many mutual funds that have minimum investment requirements into the tens of thousands of dollars.

7. Dividends Are Not Automatically Reinvested

There's nothing necessarily wrong with reinvesting dividends, but mutual funds don't even give you a choice. With ETFs, dividends are placed into your brokerage account. If you want to buy more shares of that same ETF, you certainly can, but you're given the flexibility to put the cash elsewhere.

8. There's a Big Selection, But It's Not Overwhelming

According to the Investment Company Institute, there were 1,411 available ETFs in the U.S. at the end of 2014. Compare that to about 7,400 mutual funds. The number of ETFs at this point should offer investors plenty of ways to diversify their holdings any way they choose, without drowning them in a sea of confusing choices.

Do you own ETFs? Why or why not?

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"There's nothing necessarily wrong with reinvesting dividends, but mutual funds don't even give you a choice. With ETFs, dividends are placed into your brokerage account. If you want to buy more shares of that same ETF, you certainly can, but you're given the flexibility to put the cash elsewhere."

This is wrong. You absolutely do have a choice to reinvest dividends that are produced by mutual funds. Particular brokers or retirement accounts may not allow it, but Vanguard for instance absolutely allows you to receive dividends by check or bank transfer instead of reinvesting them.