Understanding the Differences Between ETFs and Mutual Funds

Investors are often surprised by the differences between Exchange-Traded Funds (ETFs) and Mutual Funds, especially when it comes to taxes. Below is a comparison to help clarify key distinctions between these two investment vehicles and how they may impact an investor’s tax liability.

1. Structure & Trading

• ETFs trade on stock exchanges, just like individual stocks. They can be bought and sold throughout the trading day at market prices, which may differ slightly from their Net Asset Value (NAV). A NAV is simply the sum of the individual market values of each of the fund’s holdings.
• Mutual Funds are bought and sold directly through the fund company at the end of the trading day at their NAV.

2. Tax Efficiency & Capital Gains Distributions

One of the primary advantages of ETFs over mutual funds is tax efficiency, which often results in lower capital gains distributions.

• ETFs: Generally more tax-efficient due to their structure. ETF managers use an "in-kind" redemption process—allowed under Subchapter M of the Internal Revenue Code—which enables the transfer of appreciated securities through like-kind exchanges rather than selling them, thereby minimizing capital gains distributions to investors.
• Mutual Funds: More frequently distribute capital gains, particularly in actively managed funds where portfolio turnover is higher. In the absence of an in-kind exchange, Subchapter M requires the mutual fund to “pass-through” any realized gains. These distributions create unexpected tax liabilities for investors, even if they haven’t sold any shares. (For example, it is possible for an investor to hold a mutual fund investment for an entire year, experience a decline in the fund’s market value, and still have to pay taxes on capital gain distributions.)

While it is possible for an ETF to distribute capital gains, it is uncommon. This structural advantage makes ETFs a preferred choice for investors looking to optimize tax efficiency.

3. Costs

• ETFs usually have lower expense ratios compared to mutual funds. Investors may pay brokerage commissions when buying or selling ETFs, though many platforms (including Schwab) now offer commission-free trading.
• Mutual Funds may have higher expense ratios, sales loads (if applicable), and potential redemption fees. Mutual funds may also be subject to brokerage commissions.

4. Management Style

• ETFs were historically passive (index-based), but the landscape is evolving. The number of actively managed ETFs is rapidly growing, providing investors with the benefits of professional management while maintaining the tax efficiency of the ETF structure. (According to Morningstar, 603 new actively managed ETFs came to market in 2024.)
• Mutual Funds are often actively managed, which can result in higher fees but also the potential for outperformance. However, actively managed mutual funds have the potential for significant taxable distributions.

5. Minimum Investment Requirements

• ETFs can be purchased in single (and sometimes fractional) shares, making them more accessible for investors with smaller amounts to invest.
• Mutual Funds often require minimum investments, which can range from a few hundred to several thousand dollars.

6. Is Your Portfolio Optimized for Tax Efficiency?

Given the significant tax advantages of ETFs, it’s worth considering whether your current portfolio is structured in the most tax-efficient manner. At WRFA, we utilize ETFs almost exclusively to avoid unnecessary capital gains distributions, ensuring that our clients keep more of their investment returns. With the increasing availability of actively managed ETFs, investors can now access professional management without the tax drag typically associated with mutual funds.

If you are concerned about unexpected tax liabilities or want to ensure your investments are structured efficiently, we would be happy to review your portfolio and discuss strategies to enhance tax efficiency.

Conclusion

For tax-conscious investors, ETFs generally provide a more favorable option due to their ability to avoid capital gains distributions through the in-kind redemption process. While mutual funds may still be appropriate for certain investors, the advantages of ETFs—lower costs, tax efficiency, and increasing availability of active management—make them an attractive solution for optimizing after-tax returns.

If you’re interested in learning more about how ETFs can help you manage your tax exposure, reach out to us today!

Disclosure:

WebsterRogers Financial Advisors, LLC (“WRFA”) is an SEC-registered investment adviser located in Florence, South Carolina. Registration does not imply a certain level of skill or training. This material is for informational purposes only and is not intended to be a recommendation or offer to buy or sell any security. The information provided herein is based on sources believed to be reliable, but WRFA makes no representations or warranties as to the accuracy or completeness of such information. This material discusses general tax principles, which may not be applicable to all investors. WRFA does not provide legal or tax advice. Investors should consult with their tax professional regarding their specific situation before making any investment decisions. ETFs and mutual funds are subject to market risk, and their values will fluctuate. Although ETFs are generally more tax-efficient than mutual funds, they may still generate taxable capital gains under certain circumstances. Subchapter M of the Internal Revenue Code governs the tax treatment of regulated investment companies and allows ETFs to reduce taxable distributions through in-kind transfers, but this benefit may vary based on fund structure and management. For more information about WRFA’s advisory services, including a copy of our current Form ADV disclosure brochure, please visit www.adviserinfo.sec.gov or contact us directly.