Consider ETFs for retirement portfolio
Instruments have some edges over mutual funds
Hardly a day goes by when there isn’t a new exchange-traded fund launched for the benefit of investors – both those saving for and those living in retirement.
But are these the sort of investments you should consider for your retirement portfolio?
Yes, experts say, though some caveats apply.
First, a definition. An ETF, according to the Investment Company Institute, is “a pooled investment vehicle with shares that can be bought or sold throughout the day on stock exchanges at market-determined prices. Investors may buy or sell ETF shares through a broker, just as they would the shares of any publicly traded company.”
About 1,925 ETFs traded in the U.S. at the end of July, some that track the performance of the Standard & Poor’s 500 stock index and some that expose investors to China’s biopharmaceutical companies. That said, here’s what you need to know about ETFs:
Tax efficiency
Experts says ETFs are more tax-efficient than mutual funds. According to the ICI, mutual fund shareholders generally pay federal and, in many cases, state and local income taxes, including taxes on dividends and capital gains. What’s more, the ICI notes on its website that shareholders who own mutual funds outside of tax-advantaged accounts are taxed each year on two types of transactions: distributions from the fund and the sale of the fund shares.
Typically, mutual fund shareholders receive distributions from the fund in December and by and large don’t control the amount or timing of that distribution. With ETFs, shareholders don’t have to worry about distributions from the fund and only pay taxes on the sale of fund shares, which they control.
And this ability to minimize the capital gains that come with most mutual funds is an advantage for the ETF, experts say.
One caveat: “ETFs bring trading costs,” said Elisabeth Kashner, director of ETF Research at FactSet Research Systems. “For investors in tax-deferred accounts such as IRAs and 401(k)s, mutual funds offer greater cost control. Also, mutual funds offer automatic dividend reinvestment. This avoids slip- page and trading costs.”
This does not, however, mean that IRA and 401(k) investors should always choose mutual funds over ETFs, Kashner said. “Not at all,” she said. “Fund expenses and investment strategy still matter. However, in an IRA or 401(k), if you have a choice of the exact same portfolio and the exact same expenses, choose the mutual fund.”
Low expense ratios
The expense ratios for ETFs tend to be lower than for mutual funds, as well.
The average ETF expense ratio is between 0.35 percent and 0.5 percent, while the average expense ratio for actively managed mutual funds is between 0.5 and 1 percent, according to Investopedia.
And the lower the expense ratio, the more savings for the investor.
“For those of us whose retirement depends on the ability to save and invest, the magic of compounding works best when costs are low,” Kashner said. “No matter what the vehicle – mutual funds or ETFs – keep total cost of ownership as low as possible.”
Of course, an ETF, even a low-cost one, is no substitute for a plan.
“As I tell my clients, the plan comes first, then the tools,” said Michael Baker, a certified financial planner with Vertex Capital Advisors.
Trade in real time
ETFs also trade like shares of stock, in real time, so you can buy and sell them during market hours.
A mutual fund, by contrast, is priced just once a day at the close of trading. And that makes mutual funds less desirable in a volatile stock market.
What else to consider
Steve Devaney, a certified financial planner with Aisling Advisors, suggests buying ETFs based on the following criteria: the quality of the ETF provider, the index being used for passive ETFs, the assets under management and the trading volume.
Well-known, long-established indices are better than obscure indices, the more assets under management the better, and the more trading volume the better.
As a general rule, ETF experts generally advise against investing in newly launched ETFs.