Corporate-class mutual funds let you switch between funds without having to pay capital gains taxes right away. But there are reasons why regular mutual funds, as well as ETFs, make better investments

Corporate class, or “tax-advantaged,” mutual funds are classes of funds that let you switch between individual funds within the class without having to realize a capital gain. You only pay capital gains when you move entirely out of a specific family of funds.

However, corporate-class mutual funds typically have higher MERs and lower returns. Apart from the higher MERs, one reason for the lower returns is that they must hold larger cash balances to fund more frequent redemptions. With some mutual fund companies, that difference in cash-holding requirements is slight. In others, it’s more pronounced.

How to Make Money with ETFs Learn everything you need to know in 'The ETF Investor's Handbook' for FREE from The Successful Investor. ETFs Guide for Canadian Investors: Find the best way to invest in ETFs with low fees, low risk & high satisfaction.  I consent to receiving information from The Successful Investor via email. I understand I can unsubscribe from these updates at any time.

Corporate-class mutual funds come with a further potential disadvantage

The supposed advantage of corporate-class mutual funds turns out to be a disadvantage in most cases. That’s because they encourage frequent trading—and that can cause you to miss out on some of your biggest gains on rising funds.

All in all, the main criteria in choosing mutual funds should be the quality of the holdings in the funds, rather than the ability to switch from fund to fund without incurring capital gains.

We think investors should stay out of corporate-class mutual funds.

Managing mutual funds and ETFs in your diversified portfolio

Mutual funds pool money collected from many investors and use the money to invest in securities, mainly stocks and bonds. The shareholders participate proportionally in the gains or losses of the fund.

Mutual funds let small investors access professionally managed, diversified portfolios that would be difficult for them to create on their own. However, the funds in turn charge investors management fees.

You can think of ETFs as highly efficient mutual funds. Their fees are lower than those of mutual funds because investors don’t pay for active management. Instead, ETFs aim to mimic the performance of a market index, by holding the same securities in the same proportions used to calculate the market index.

ETFs trade on stock exchanges, just like stocks. That’s different from mutual funds, which you can only buy at the end of the day at a price that reflects the fund’s value at the close of trading.

As well, shares are only added or removed from traditional ETFs when the underlying index changes. As a result of this low turnover, you won’t incur the regular capital gains taxes generated by the yearly distributions most conventional mutual funds pay out to unitholders.

Key point: Here’s a good general rule to follow when choosing investments: Simple is better. The easier an investment is to explain and understand, the less likely it is to harbour hidden risks and costs that can only work against you. As the old investor saying goes, “Stick with plain vanilla.”

Investing in ETFs over corporate-class mutual funds

We think that in general mutual funds are okay to hold if you already own them, but we have moved away from recommending them in favour of lower-fee exchange-traded funds (ETFs). We feel that most mutual fund investors should shift into ETFs wherever possible. (For that reason, we shifted our focus in our Canadian Wealth Advisor newsletter to ETFs.)

A top ETF investment can be a good low-fee way to hold shares in multiple companies with a single investment.

A top ETF will not participate in trying to “beat the market” or in market timing

Of course, we stay out of ETFs that use leverage, or that aim to somehow “beat the market” or try and time the market

We’ve found that our exclusionary rules leave us plenty of scope for sound investing, with lots of high-value opportunities and few surprises. In investment innovations, surprises tend to be unpleasant. That’s because most innovations are aimed at selling more “product” (as brokers say) to investors, rather than raising investor returns. Some innovations may give you greater stability, steady income or tax deferral, but you generally pay for these advantages out of your total investment return.

The best ETF investments include the following characteristics:

• Diversification: Diversification is one of the most attractive features of ETFs. An investor could create an entire balanced portfolio solely from a few well-diversified ETFs.
• Lower MERs: The MERs (Management Expense Ratios) are generally much lower on ETFs than on conventional mutual funds. That’s because most ETFs take a much simpler approach to investing.
• Low turnover for index ETFs: Shares are added or removed when the underlying index changes. But with ETFs, you won’t incur the regular capital gains taxes generated by the yearly distributions most conventional index mutual funds pay out to unitholders.
• Tax and cost-efficient: ETFs are typically more tax-friendly and cheaper than comparable mutual funds.

What is your opinion on corporate-class mutual funds? Do you find the billed tax advantage worth the downsides?

This post was originally published in November 2021 and is regularly updated.