For nearly a century, when investors wanted a professional to manage their stocks or bonds, they turned to a tried and true vehicle mutual funds. But over the past few decades, the mutual fund has been losing the battle for investors' attention, primarily to exchange traded funds, but also to things like separately managed accounts and direct indexing. Does this mean we're at the end of the famed mutual funds? Four one ks and mutual funds and mutual funds and exchange traded
fund mutual funds and other investments? Everything is down on mutual funds.
I think most mutual funds, many mutual funds and index funds that are owned by consumers.
I'm Barry hilt and on today's edition of At the Money, we are going to discuss what fund wrapper is best for your capital. To help us unpack all of this and what it means for your portfolio, let's bring in Dave Nadig. He is financial futurist at Vetify and a well known ETF industry pioneer. So, Dave, I'm gonna throw another of your quotes back at you. If the mutual fund was invented today, it wouldn't get regulatory approval, absolutely not.
Explain well, the key thing about a mutual fund that's different from an ETF is primarily how the money gets in and out and then how it's taxed. And the reason mutual funds are inherently at this point an inferior structure to ETFs for almost everything is how that money
gets in and out. So when you put money in a mutual fund, Barry, you send money virtually to say Fidelity, and then they take that cash and then they go buy a bunch of stocks, and then when you want to take your money out, they say, oh, Berry wants his money back, They sell a bunch of stocks and they give your cash. It can be a little bit more complicated than that, but.
That's a core aspect. You send them cash and they go out to the marketplace and make purchases on your behalf within the structure of everybody else in that fling exactly.
And that sounds great and it's a fantastic structure. It's actually been going back since the fourteen hundreds in the Dutch East India company right that kind of pooled mutual structure very straightforward. The problem is when you decide to sell the tax bill for any gains and selling all those stocks so you can get your one hundred million dollars back. That tax bill notionally gets applied to the entire pool. Now it's not as bad as it sounds. I don't have to pay taxes that I never get
back just because Berry is sold. However, I will have to deal with that this year. Left to just my basis, I will get a distribution. I'll get a taxable gain that shows up on my IRS report even though you didn't sell without selling a darn thing. So anybody who's owned a mutual fund and a taxable account knows this. You get a distribution you didn't sell anything. Some of that's dividends from stocks or coupons from bonds, but some of it's just, hey, we bought and sold some stuff.
We have to pass that out every year. That's the rule the IRS has. And by passing that out, you mess with every holder of that fund's axis for that year, and they take away a timing benefit because you have to recognize that this year even though somebody else sold.
So now do a compare contrast with an ETF. How is it different in terms of capital gains distributions.
The primary difference is that the ETF is rarely buying and selling anything on behalf of the whole pool. When new money comes into the fund, it's because Barry, you went out, you bought one hundred million dollars. You caused it to be a little more expensive. That makes these other folks, these authorized participants that you never have to worry about, do the actual creation of new shares of the fund you want with the issuer, and they do that by buying all those stocks and just handing them
over to the fund. The same thing happens in reverse, and because no sale happens with big air quotes around it, it's all happened in kind. The IRS doesn't treat that as a taxable event.
Explain in kind in other words, So with a mutual fund, I'm literally selling here's one thousand dollars, and they say we have one hundred stocks. Are gobat and buy a thousand dollars worth of stocks. Literally, It's that simple. When you say in kind transaction, how is it different with an ETF.
Well, from the individual investors perspective, you just buy an ETF like a stock, So it's really simple. You buy it, you sell it, easypasy.
So then how do these funds get created? If I'm buying something that's trading every day.
Well, if enough people are buying at the same time, the price of the ETF will go up a little bit. When it goes up enough so that it's actually a little bit overvalued compared to the underlying basket of stocks. These arbitrajurors step in and they create those shares and they're allowed to. There's a whole system for that that is an individual investor you don't have to know about. But the end result is the tax liability gets washed, it gets pushed forward into the future. So your spy holdings,
you're not going to get capital gains distributions. You might still get dividends, that's still going to happen, but your capital gain is going to be based on when you choose sell it. So if you buy it at four hundred and sell it at five hundred, you have a personal one hundred dollars gain that you report on your taxes. It's very clean, it's very simple, and it's tax efficient and tax fair.
So that that seems to be one reason why ETFs are attracting a lot of capital that previously we're either flowing to mutual funds or as we've seen, come out of mutual funds and head headed to ETFs. Before we get to enthusiastic about exchange traded funds, what are the downsides of these?
Well, you do have to know how to trade, right, and if you're not comfortable buying and selling Microsoft stock, you should not be out there by buying and selling spy the S and B five hundred spider because it has the same issue in the sense that there's a price you pay to get it, then there's a price you pay when you sell it. Then there's a gap in that and if that gap is very wide, that spread is very wide, then that's friction on your on your and that's all return right, So that's it's sort
of a hidden cost to trading. So I always say you need to be comfortable with trading hygiene, right, you need to understand the basics of how to get a trade in how not to get messed up there. Then it's really straightforward. That's the primary issue. The other thing I think investors can get a little over their skis on is because we have so many ETFs in the market now, and the structure is incredibly flexible. You can get access to all sorts of stuff that may or
may not actually belong in your portfolio. You want triple leveraged inverse oil futures, you can get that in an ETF wrapper. You probably shouldn't.
Okay, right to say the very least. So if the downside to owning mutual funds is these phantom capital gains, that suggests that if you have a tax defert account, a four oh one k, an ira four h three be anything like that, mutual funds probably can live very comfortably in those sort of accounts.
Absolutely. And you know, in my own personal portfolio, I use a whole bunch of index mutual funds that happen to be available in those retirement plants, and they do a great job, and there's no reason not to have them there. And in fact, there are some reasons why mutual funds are better in that environment. Most people who contribute to their I R or their four to zoe K don't think about it in shares. They think about it in dollars. You know X percent of my paycheck.
Now I've got three hundred and eighty dollars more in my four ROH one k, you want that three hundred and eighty dollars split into whatever funds you had. But if you were doing that in ETFs, you have to buy an individual share, which might be twenty five or one hundred and twenty five dollars for one share. It's very noisy. You're not going to be able to make your allocation perfectly. Mutual funds don't trade that way. They
trade in fractional shares to the fifth decimal point. So even if you're trying to get a dollar to work, you can split that dollar across five different funds.
Wow, that's interesting. So is it a little premature to say that we're looking at the death of mutual funds? Is it more accurate to say these things are evolving and ETFs and mutual funds are all serving different purposes.
I think that's the world we're headed toward. The old phrase I like to use is, you know, different horses for different courses. You know, put the horse racing vets on it. You know, there are some use cases, particularly around retirement. As you highlighted. The other sort of edge case in mutual funds is sometimes you want to close a fund if you're a small cap special situations manager, you may not be able to run ten billion dollars the way you could run two hundred million dollars, So
you cap it two hundred and you close it. And in fact, a lot of the best performing mutual funds out there, year after year are closed to new money. And that's because somebody has some sort of edge, usually in an active management context, and they can only express that edge at a certain size. You cannot do that in an ETF. You can't close an ETF for new money because that whole mechanism we just talked about about
buying and selling it in the market. That'll get haywire because now you can't make or get rid of any of them.
So let's tie all this up together. Mutual Funds have been around for forever. Practically the Forties Act nineteen forty is the legal documents that created what is essentially the modern mutual funds. Typically, what we've seen over the past few decades is the rise of a lot of alternative wrappers to purchase stocks and bonds, and as an investor, you need to think about what sort of holding you have in order to figure out where to locate those assets.
If you're an active mutual fund that has a lot of transactions and a lot of phantom capital gains taxes, well that's something you want in a four oh one K or an ERA. If, on the other hand, you are holding something in your portfolio that's not tax deferred, hey, that's the perfect opportunity for an ETF, and a lot of fun companies will offer you both whatever you want. You want the S and P five hundred, you get that in ETF, you can get that in mutual fund.
Just about all of the big companies offer parallel mutual funds and ETF these days. Be careful about where you put those funds. It'll make a big difference to your tax paym and your bottom line. You can listen to At the Money every week finding in our Master's and business feed at Apple Podcasts. Each week we'll be here to discuss the issues that matter most to you as an investor. I'm Barry Rittolts. You've been listening to At the Money on Bloomberg Radio