Apples to Apples? Mutual Funds vs. ETFs

Let’s start with the basics. What is a mutual fund and how does it work?

A mutual fund is a pool of money received from investors that is managed by an investment company. Mutual funds issue and redeem shares at their net asset value (NAV), the price at which you can buy or sell a share that is calculated after the market closes for the day. So when you put an order in to buy or sell a mutual fund, it’s not executed until after the market is closed. This is why you can’t specify the price at which you’d like to buy a mutual fund, as the price is unknown until the market closes and the NAV is calculated. Instead, you have to specify the amount you want to invest in a mutual fund, for example $2500 worth of ABCDE mutual fund, and then the quantity of shares you end up with is determined by the NAV.

Moving on to ETFs – what is an ETF and how does it work?

ETF stands for exchange-traded fund (literally, traded on the stock exchange) and is a collection of assets that tracks an index. Examples are ETFs that track the S&P 500 or the Russell 2000, a sector like energy or biotech, a country or region like Vietnam or the Caribbean basin, a commodity like gold or coffee, or a currency, among others. ETFs offer more trading flexibility than mutual funds as they trade continuously when the market is open and can be sold short or bought on margin. As such, ETFs are traded at their current market price instead of their NAV, like stocks.

Tax

Investment returns of mutual funds are granted “pass-through status” under U.S. tax code, meaning that taxes are paid by the investor, not the mutual fund. When capital gains and dividends earned in the mutual fund are paid out to investors, typically once or twice a year, investors are liable for taxes on this income. This can lead to a few undesirable scenarios. One, the investor who just bought shares and receives a distribution is liable for taxes resulting from transactions that occurred before they bought the shares. This is a common concern late in the year when distributions are often made. Two, if the mutual fund loses value, particularly below the price at which it was originally bought, the investor is still liable for taxes on it. In general, owning mutual funds reduces the investor’s ability to manage their taxes.

By contrast, ETFs are much more tax-efficient as they are structured to shield investors from capital gains taxes. Redemptions of ETFs do not trigger a stock sale within the fund as they do in mutual funds, so no capital gains or any resulting taxes are passed on to investors. Of course, the investor is still liable for taxes with ETFs if they realize capital gains upon selling them or receive dividends.

Cost

Mutual funds are relatively expensive to own. Since they are actively managed by an investment company, the company incurs an array of fees that cuts into returns. These fees can be divided into two main categories. The first category is the operating expenses of the fund, which includes the cost of paying the fund managers, administrative fees, and sales and marketing fees (aka 12b-1 fees). These expenses are expressed as an expense ratio, which ranges from 0.2-2.0%, and the average mutual fund has an expense ratio of 1.25-1.5%. The second category is front- or back-end loads, which are sales commissions charged upon buying or selling the mutual fund. On the brighter side, there are no-load mutual funds available.

ETFs are significantly cheaper to own. Investors who buy ETFs do so through brokers, rather than buying directly from the fund. As a result, ETFs have lower sales and marketing fees, which translates into lower operating expenses that cut into returns. On the other hand, ETFs come with a trading cost. Unless they are a proprietary fund where the fee is waived, ETFs incur a brokerage commission.

Relatedly, the cost of buying in can be a deterrent for mutual funds. ETFs are more accessible to investors as they don’t have minimums, whereas mutual fund minimums can range from $5,000-$50,000.

Investment Strategy

Mutual funds are run by professional money managers who do the research to make the buying and selling decisions within the fund. The goal of this active management is to beat the market. For some investors, the allure of outperforming the market justifies the higher cost of owning the fund.

ETFs are overseen by professional money managers who try to match the ETF’s performance to its benchmark index and minimize capital gain distributions. The goal of this passive management is to track the market and not risk underperformance. For some investors, the perceived safety of a passive strategy is more desirable than the heightened uncertainty of an active strategy.

Pick Your Own

Overall, mutual funds offer an active management strategy designed to beat the market, at a relatively high cost, whereas ETFs offer a passive management strategy designed to track the market, at a relatively low cost. Mutual funds have more trading limitations than ETFs, but there are more mutual funds to choose from than ETFs. Many people want to know, which fund type is better? Not surprisingly, it depends on the investor’s financial situation.

For investors who manage their own portfolios, mutual funds could be preferable for those with a longer time horizon and little interest in trading, and ETFs could be preferable for those with a shorter time horizon and interest in more frequent trading. When considering taxes, ETFs could be better for investors who are sensitive to taxes. When considering performance, ETFs could be less compromised by fees, but mutual funds could have higher returns. And for investors who use investment managers to manage their portfolios, it is important to take a meta view with either fund type, as the success of the investment strategy is presumably the key determinant.

Unlikely Bedfellows: Social Security & Divorce

Through a little known Social Security benefit, our government recognizes the financial value of the work that stay-at-home moms do to support their families. We all know that the stay-at-home mom is on the job around the clock and it’s hard to put a dollar value on her estimable contributions.

But if marriage ends in divorce, the stay-at-home mom’s financial dependence can be calamitous. The opportunity cost of the mom staying home can be high, as it’s harder for her to reenter the work force the longer she is out of it. She also has to defer building a career and developing expertise, with commensurate pay, and she loses the chance to save for retirement and benefit from the magic of compounding interest. While alimony and child support can help protect a lifestyle for the mom and children post-divorce, Social Security offers a divorced spouse’s benefit to the mom to help with retirement.

Of course, these are gender-neutral benefits, and more dads now than ever are assuming the role of the supporting spouse. When I use the term mom, is it only because it is still more common that women are the ones who choose to take the off ramp, but there are certainly many dads to whom this applies.

The Rules

Divorced spouses are eligible for a benefit if:

1. They were married to their ex-spouse for 10 years.
2. They have been divorced for 2 years.
3. They are not remarried, and if they did remarry that marriage ended.
4. Their ex-spouse is eligible for benefits.

If these criteria are met, divorced spouses can claim ½ of their ex-spouse’s full retirement amount at their Full Retirement Age (FRA), which is between age 65-67 depending on their birth year, or a reduced benefit at age 62, similar to what they could claim if they were still married to their ex-spouses.

The Nitty Gritty

Must take higher benefit.
If the divorced spouse’s own benefit is higher than ½ of their ex-spouse’s benefit, the divorced spouse must take their own benefit.

Does not include delayed retirement credits.
The divorced spouse’s benefits do not include delayed retirement credits for which the ex-spouse is eligible. Delayed retirement credits accumulate when benefits are delayed past FRA, and increase by a percentage each year until they max out at age 70. For example, if the birth year is 1943 or later, benefits increase by 8% per year, which is a mighty fine rate of return.

Can optimize benefits by filing a restricted application.
If the divorced spouse was born before January 2, 1954, they can optimize their benefits and take both over time. Specifically, the divorced spouse can take the divorced spouse’s benefit, let their own benefit accumulate until it becomes higher than the divorced spouse’s benefit, then switch. This claiming strategy is considered a loophole and was closed for anyone born January 2, 1954 or later in the Bipartisan Budget Act of 2015.

Ex-spouse’s filing status is immaterial.
The ex-spouse does not need to have filed for benefits for the divorced spouse to file on the ex-spouse’s record.

Ex-spouse’s marital status is immaterial.
It doesn’t matter if the ex-spouse is remarried, as the divorced spouse’s claim to the benefit does not affect the ex-spouse’s record or the ability of any current spouse to claim benefits.

The Lowdown

There’s nothing simple about Social Security or divorce, but the welcome news is that a divorced spouse’s benefits could add up to a windfall of thousands of dollars per year. If a couple is considering divorce after 9 years and 11 months it could behoove them to wait a month. The vow “for richer or poorer” may not have endured, but Social Security has a palliative for that.

Just Say No to Variable Annuities

Variable annuities are private financial contracts that provide income for a specified period of time, such a number of years or for life, and are tied to the investment performance of the mutual funds held in the contract. While the promise of a fixed income stream is enticing, I’ll level with you about the many downsides. In short, variable annuities are expensive, restrictive, and unnecessarily complicated financial products that offset any financial benefits they claim to offer.

Caveat emptor (“Buyer beware”). The salesperson pushing a variable annuity is largely motivated by the high commissions they will receive from selling it. I belong in the camp where if you are a financial professional, your fiduciary duty is implicit and paramount, and the client’s best interests always come first. The financial professional should never be incentivized to undermine the client’s best interests for their own gain. However, in the case of variable annuities, there couldn’t be a more egregious conflict of interest.

Here is a plethora of reasons not to buy one:

Commissions. Annuities are primarily front-end loaded, commission-based products. When a salesperson tries to sell you an annuity, don’t be afraid to ask about the commission they collect by selling it to you. Annuity firms can pay out commissions of 5% or more. Reality check: for each $100,000 you plunk into the annuity, that’s $5,000 or more in commissions. Furthermore, the mutual funds held in the annuity charge commission-like fees in the form of front-end loads, back-end loads, and 12b-1 fees.

Surrender charges. Most annuity firms charge a hefty surrender fee, usually on a seven year scale. For example, a $100,000 investment could cost you $8,000, or 8%, in surrender charges if you take your money out in the first year. The surrender charges usually go down 1% per year until reaching 0% at the end of the surrender period.

Fees. Additionally, there is a raft of dubious fees that may be charged by the annuity firm. This can include, but is not limited to, any of the following: asset fees, management fees, annual fees, quarterly transaction fees, withdrawal fees, rider fees, administrative fees, mortality and expense fees. With fees in aggregate costing between 2-4% annually, it’s difficult for investors to make money. At best, stated interest rate contracts (often called “guaranteed” interest rate contracts) may end up only paying out the stated rate (like 2%) because the rest is negated by fees. At worst, the fees negate any profits whatsoever.

Risk. The value of a variable annuity goes up and down with the market, so growth is not assured. Consider what would happen if the annuitant were to die prematurely. If the annuity has not been annuitized, the beneficiaries receive the value of the account. Depending on investment performance, this could be significantly less than what was originally invested. Or, if the annuity has been annuitized, all payments cease, even if only one payment has been made.

Irreversible consequences. Once you annuitize, you give up the ability to recover your lump sum or pass it on to beneficiaries. For example, if you put $250,000 into an annuity at age 60 and agree to receive a monthly income for the rest of your life, it could take 25 years to break even. It’s worth belaboring my last point as well – all payments cease at the death of the annuitant.

Poor tax planning. Once you put after-tax dollars into an annuity contract, withdrawals are taxed as ordinary income rather than at more favorable long-term capital gains rates.

Inflation. Rates are currently at historic lows, and will increase in the future. Over time, the purchasing power of fixed annuity payments is greatly reduced by inflation.

No socially responsible choices. Most annuities do not have any environmental, social, or governance screens that measure sustainability and ethics in regard to investments. As such, your investments may be supporting companies not aligned with your values.

Intentional derangement. Annuity contracts seem to be complex on purpose and the salespeople who tout them seem to skimp on disclosure. If the annuitant doesn’t fully grasp the terms of the contract, this benefits the salesperson, who likely doesn’t fully understand it either. Numerous clients have come to me with annuity contracts from other financial professionals and they can’t make heads or tails of them, and they certainly aren’t aware of all the limitations. Older retirees in particular are vulnerable to this dishonorable practice.

These myriad pitfalls of variable annuities add up to a vehement Do Not Touch With A Ten-Foot Pole rating.