01 Mar Pay cap gains tax or risk market downturn?

Q. I’ve had some mutual funds since the 1990s, riding the market up and down with them and even adding to them once in a while. Now that I’m in my 60s, a friend said I should move them to exchange-traded funds so they would be easier to sell if the market drops suddenly. He’s talking about putting stops in place so I could exit the fund at say maybe a 5 percent loss. Wouldn’t I be hit with capital gains if I sold my mutual fund? Is it worth the capital gains just to have a faster way to sell?
— Investor

A. We’re glad to hear you’ve been able to stomach the ups and downs of the market for so long.

Your friend may have a point, but make sure you look at your overall asset allocation before you decide to sell any investments.

To your specific question, if your mutual funds are held outside of a tax-deferred retirement account, then yes, you would need to pay capital gains on any appreciation from the mutual fund, said Nicholas Scheibner, a certified financial planner with Baron Financial Group in Fair Lawn.

Your question is basically asking if exchange-traded funds (ETFs) are better than mutual funds.

Not necessarily, and not all ETFs are the same.

Scheibner said you may be hearing about low- or no-expense ratio ETFs, but cost is not the most important factor when investing in an ETF. The most important factor is liquidity, he said.

“You want to make sure that the ETF you’re investing in has a high daily volume of trading,” he said. “Everything can seem great with an ETF when markets are going up, but when things are going down and you want to sell out of your fund, you may take a big loss.”

Think of it this way: Picture a room with 100 people and a door that can only fit one person at a time. Imagine everyone wanting to leave the room at the same time, Scheibner said.

As you can imagine, there would be a rush to the door, and it would be difficult for everyone to get out – and a similar theory applies to ETFs, he said.

“If there are very few people trading an ETF on a daily basis, it can be difficult to sell at the price you would like,” he said. “You want to invest in an ETF that has a lot of activity — a large door — so that when you want to exit, you can at a reasonable price.”

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This post was first published in March 2018.