Many mutual funds are converting to exchange-traded funds. Here's what investors need to know (2024)

FAQs

Why are mutual funds changing to ETFs? ›

For some, switching to ETFs makes sense because the expenses associated with mutual funds can consume a portion of profits. Also, if you prefer an investment that will grow in value over time without increasing your tax liability each year through capital gains distributions, ETFs can be beneficial.

The conversion itself is tax-free to the investor and switches from actively managed mutual funds, which aim to outperform the market. The primary benefit of the new ETF is more tax efficiency.

Per Fidelity Investments, since March 2021, 70 mutual funds have converted to ETFs.

Mutual funds are usually actively managed, although passively-managed index funds have become more popular. ETFs are usually passively managed and track a market index or sector sub-index. ETFs can be bought and sold just like stocks, while mutual funds can only be purchased at the end of each trading day.

Neither mutual funds nor ETFs are perfect. Both can offer comprehensive exposure at minimal costs, and can be good tools for investors. The choice comes down to what you value most. If you prefer the flexibility of trading intraday and favor lower expense ratios in most instances, go with ETFs.

ETF trading generally occurs in-kind, meaning they are not redeemed for cash. Mutual fund shares can be redeemed for money at the fund's net asset value for that day. Stocks are bought and sold using cash.

Positive aspects of ETFs

The 4 most prominent advantages are trading flexibility, portfolio diversification and risk management, lower costs versus like mutual funds, and potential tax benefits.

The simplest way to avoid this is to own mutual funds in tax-advantaged retirement accounts such as IRAs and 401(k)s. You can also make sure to hold the investments for the long term, so that if you do owe taxes, you'll pay them at the lower long-term capital gains rate.

Do you pay taxes on ETFs every year? ›

For ETFs held more than a year, you'll owe long-term capital gains taxes at a rate up to 23.8%, once you include the 3.8% Net Investment Income Tax (NIIT) on high earners. If you hold the ETF for less than a year, you'll be taxed at the ordinary income rate.

ETF capital gains taxes

Of course, investors who realize a capital gain after selling an ETF are subject to the capital gains tax. Currently, the tax rates on long-term capital gains are 0%, 15%, and 20%.

Under the Investment Company Act, private investment funds (e.g. hedge funds) are generally prohibited from acquiring more than 3% of an ETF's shares (the 3% Limit).

How many ETFs are enough? The answer depends on several factors when deciding how many ETFs you should own. Generally speaking, fewer than 10 ETFs are likely enough to diversify your portfolio, but this will vary depending on your financial goals, ranging from retirement savings to income generation.

"You can get broad-based diversification with one ETF, commonly referred to as diversified ETFs, or you can build a portfolio of five to 10 ETFs that would offer good diversification," he says. The choice you make on the above depends on your investment goals and risk appetite, like any investment.

Mutual funds may eventually become obsolete. But they're still a very long way from being dead, especially those that charge reasonable fees, have sound and repeatable processes that have delivered impressive long-term results, and are managed by strong investment teams.

ETFs are considered to be low-risk investments because they are low-cost and hold a basket of stocks or other securities, increasing diversification. For most individual investors, ETFs represent an ideal type of asset with which to build a diversified portfolio.

The administrative costs of managing ETFs are commonly lower than those for mutual funds. ETFs keep their administrative and operational expenses down through market-based trading. Because ETFs are bought and sold on the open market, the sale of shares from one investor to another does not affect the fund.