Portfolio Management March 8, 2015

    While both actively managed mutual funds and exchange-traded funds (ETFs) offer investors the opportunity to broadly diversify their portfolios, several important differences can affect your long-term outcome. One of those is portfolio turnover, or the percentage of a fund's underlying holdings that changes over the course of a year.

    In an effort to beat the market, some actively managed mutual funds trade so frequently that their turnover approaches 100%. Most ETFs, however, track market indexes, and because index constituents change relatively infrequently, the ETFs that track them seldom change their underlying stocks. As a result, ETF portfolio turnover is generally low.

    The Perils of High Turnover

    Every time a mutual fund buys or sells securities it incurs transaction costs in the form of brokerage commissions and the bid-ask spread (the difference between the price at which an asset is offered for sale and what a potential buyer is willing to pay). These costs can eat into a fund's returns.

    Indeed, a 2013 study published in the Financial Analysts Journal concluded that actively managed mutual funds' average annual trading costs of 1.44% exceeded their average annual expense ratio of 1.19%.1 Of course, some types of mutual funds tend to trade more often than others. Small-cap growth equity funds, for example, had an average aggregate trading cost of 3.17%.2

    Now, let's compare to ETFs, which make trades not to beat the market, but to track their index. Typically, a market index is updated to reflect changes to its underlying companies. For example, a company in a mid-capitalization stock index might grow or shrink to the point where it would better fit in a large-cap or a small-cap index. Alternatively, companies might merge or be spun off. But overall, these occurrences are relatively infrequent, resulting in limited trading in any ETFs that track those indexes.

    Taxing Turnover … Or Not

    Each time a mutual fund sells one of its underlying securities at a profit, it generates capital gains for its shareholders. But, while mutual fund trading may afford investors the opportunity to outperform the market—an advantage index funds don't offer—any profits resulting from that management are taxable, assuming the funds are held in a taxable account.

    ETFs, on the other hand, don't usually buy and sell securities. Rather, the ETF sponsor exchanges shares of the ETF with a specialized broker (or "authorized participant") for a basket of the securities in the index. Because they are trading shares rather than buying and selling securities with cash, these transactions are considered "in-kind redemptions," and typically do not register as taxable events for ETF shareholders, regardless of the type of account.

    It's What You Keep that Counts

    Each trade within your mutual fund probably won't cost you that much, and your capital gains taxes on each underlying security might not be that onerous—after all, you wouldn't be paying taxes if you hadn't made money on an outperforming fund. But small savings on investment expenses can add up over time, thanks to the power of compounding returns.

    That's one reason why ETFs are Schwab Intelligent Portfolios'™ preferred means of participating in the markets. They facilitate diversification at a comparatively low price, helping portfolios weather market volatility and potentially leading to better results over the years.

    1. http://gsm.ucdavis.edu/sites/main/files/file-attachments/edelen_sheddinglighttradingcosts.pdf

    2. Ibid.

    Tax-loss harvesting is available for clients with invested assets of $50,000 or more in their Schwab Intelligent Portfolios™ account. Clients must enroll to receive this service.

    Diversification and rebalancing strategies do not ensure a profit and do not protect against losses in declining markets.

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