Mutual funds and Exchange-Traded Funds (ETFs) are two of the most popular investment vehicles today and are standard features of most investors’ portfolios. While similar in many ways, these two options have some crucial differences that ought to be considered by the prudent investor looking to minimize costs, achieve smart diversification, and manage taxes in their portfolios.
History of Mutual Funds and ETFs
Mutual funds have a longer history than ETFs, with the first US Mutual Fund created in 1924. They were developed to give small investors access to diversified, professionally managed portfolios. The basic idea was to pool money from many investors to buy a large selection of securities with a defined investment objective. This diversification was meant to reduce risk while providing access to professional management, making investing more accessible to the general public. Mutual funds are strictly regulated, with requirements dictating the percentage of holdings that can be owned by a given fund and annual income distribution requirements.
ETFs are a more recent innovation, with the first US ETF appearing in 1993. They were developed as a hybrid of mutual funds and stocks. Like mutual funds, ETFs hold a diversified portfolio of assets. But unlike mutual funds, ETFs are traded on stock exchanges and can be bought and sold throughout the trading day at market-determined prices. ETFs are subject to regulatory requirements similar to Mutual Funds.
An important distinction is that Mutual Funds are not bought and sold throughout the day. Instead, their Net Asset Value (NAV) is recalculated daily at the end of the trading day, and that will determine the price at which a buyer or seller can place an order to purchase or sell shares at the next market opening. This contrasts the ETF, which trades regularly throughout the day and experiences fluctuating prices similar to any other publicly traded security.
Pros and Cons of Mutual Funds and ETFs
Mutual Fund Pros:
Diversification: A single mutual fund can hold hundreds of different securities, spreading out the risk of any given company dropping in value, going bankrupt, or chronically underperforming the broader market.
Automatic Reinvestment: Dividends and other distributions can be automatically reinvested to buy more shares. This can do wonders for your portfolio as compound interest will work magic to increase returns over time.
Mutual Fund Cons:
Costs and Fees: Mutual funds often come with higher fees, including management fees and sometimes sales charges (loads).
Limited Trading Opportunities: Mutual Funds are only priced at the end of the trading day, so you can’t take advantage of intraday price movements.
Minimum Investments: Many mutual funds require a minimum investment, which can be a barrier for some investors.
Exchange-Traded Funds (ETFs) Pros:
Flexibility: ETFs can be bought and sold like stocks throughout the trading day.
Lower Costs: ETFs generally have lower expense ratios than mutual funds.
Tax Efficiency: The structure of ETFs often leads to fewer capital gains distributions, making them more tax-efficient.
Exchange-Traded Funds (ETFs) Cons:
Brokerage Commissions: Buying and selling ETFs typically incur brokerage commissions, although many platforms now offer commission-free trading.
Intraday Pricing Volatility: Prices can fluctuate more than mutual funds since they are traded throughout the day. This can lead investors to trade more frequently and stray off course from their longer-term investment objectives.
Professional Management….both a Pro and a Con: Investors can access professional fund managers who make all the buying and selling decisions. These individuals are trained and experienced and spend their days (and often nights and weekends) researching companies, industries, and the economy to make deliberate investment decisions. There have been some good ones in history. Still, it cannot be overstated enough that the ability of a specific fund manager to outperform the market year after year consistently is incredibly small. Less than 10% of actively managed mutual funds were able to beat their benchmark index over twenty years, according to a New York Times article from 2022. Often, a passively managed index fund – whether a mutual fund or an ETF- will be a better option for most investors.
Making the Choice: Mutual Fund vs. ETF
The choice between a mutual fund and an ETF depends on the individual investor’s needs, goals, and preferences.
Trading Flexibility: If an investor wants the ability to buy and sell throughout the trading day and take advantage of price fluctuations, ETFs are the better choice.
Management Style: A mutual fund might be more appropriate for those who prefer having a professional actively managing their investments and deciding what to buy and sell. However, ETFs are often the preferred vehicle for investors who prefer a passive, long-term strategy that tracks an index. However, investors need to be aware of ETFs’ fees and underlying investment objectives – in recent years, a growing number of complex and riskier ETFs have been issued. For example, investors looking to invest passively in an S&P 500 ETF (ticker: SPX) might inadvertently find themselves invested in a triple-levered inverse S&P 500 ETF (ticker SPXU)…one letter difference in the ticker and world of hurt for the uninformed investor.
Costs: Investors mindful of fees might lean towards ETFs due to their generally lower expense ratios and lack of load fees. However, they need to consider other costs like brokerage commissions.
Investment Minimums: Mutual funds often have minimum investment requirements, which can be a barrier for some. In contrast, the minimum investment for an ETF is the price of one share, making it more accessible for smaller investors.
Tax Considerations: ETFs are often more tax-efficient due to their unique creation and redemption process, which can minimize capital gains distributions. ETFs might be more attractive for investors in higher tax brackets or those concerned with tax efficiency.
Dividend Reinvestment: Mutual funds often make it easy to automatically reinvest dividends, which can be a significant advantage for long-term, growth-oriented investors. While some brokerages offer similar services for ETFs, they are not as universally available.
Both mutual funds and ETFs offer unique advantages and disadvantages. Mutual funds provide professional management and automatic reinvestment but have higher costs and less trading flexibility. ETFs offer lower costs, tax efficiency, and intraday trading but often lack active management and can incur brokerage fees. The choice between the two depends on personal financial goals, investing style, and the specific circumstances of the individual investor. As with all financial decisions, it’s advisable to consult with a financial advisor to determine the best investment vehicle for your specific needs and goals. Just ensure your advisor is acting in your best interest, not their own. Happy investing!
The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax or financial advice. Please consult a legal, tax or financial professional for information specific to your individual situation.
This content not reviewed by FINRA
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