Mutual Funds and ETFs: What Are They and Which is the Better Investment For You
We’re back and, as promised, this month we’ll be explaining the differences between Mutual Funds and Exchange Traded Funds (ETFs). We’ve covered Budgeting, Determining the Best Types of Investments for your needs, and Understanding Stocks and Bonds. This month we’ll be addressing Mutual Funds and EFTs.
A mutual fund is a professionally managed investment fund that pools money from multiple investors to buy a variety of securities in diverse corporations. Each mutual fund is made up of shares that represent holdings in various businesses and industries.
When you invest in a mutual fund, you own shares in the investing company. The investing company then purchases shares in other companies. In this case, the terms “shares” and “securities” mean the same and are interchangeable. Mutual Fund investors don’t actually own stocks in the underlying companies: you do get to share equally in the profits, or losses, of the underlying companies.
ETFs are funds made up of a variety of securities that are bought and sold through a broker. The ETF provider owns the underlying securities in the fund, and the investors in the fund own a portion of the fund. However, the ETF investors do not own the underlying assets in the fund. Rather, the investors share in the profits and losses of the entirety of the fund.
Based on the above, Mutual Funds and ETFs sound like the same thing, right? On the surface, they are very similar.
- Both are investment vehicles that allow easy diversification of your portfolio.
- Both are relatively inexpensive
- Someone else is doing the hard research to determine what is worth investing in.
And these are all great things for you, the investor!
It’s only when we dig a little deeper that we start to see the differences. This is where you determine which is the better investment option for your personal needs, from both the short and long term perspective.
Differences between Mutual Funds and ETFs
Mutual Funds are typically actively managed. A professional fund manager buys and sells stocks using investing expertise to try and beat the market. They are trying to earn you a higher return on your portfolio than the market is returning as a whole. Mutual Fund managers pick which securities to buy and sell and when. Actively managed funds require more time, effort, and man-power than a passively managed fund, which results in higher costs for the investor.
ETFs are usually passively managed. Passively managed funds automatically track an index, like the S&P 500. Fund managers are not actively trying to out-perform the market; they are trying to mimic the market.
The above reflects the norm. It is important to note there are some passively managed mutual funds and some actively managed ETFs.
Some investors justify the cost of an actively managed fund by the hope that their fund will out-perform the market and generate big returns. However, according to the S&P Dow Jones Indices Scorecard, 92.33% of actively managed funds that invest in large companies fail to beat their benchmark. Perhaps not the best way to invest unless you really have the excess cash to risk …
2. TRADING METHODOLOGY
A second difference between Mutual Funds and ETFs is the way they are traded.
Mutual funds are priced and traded at the end of each trading day. By the very nature of their longer-term investment intent and strategy, many mutual funds have no transaction fees and no sales commissions.
ETFs are traded throughout the day like stocks, so their prices are determined by supply and demand. Because ETFs trade like stocks, there is usually a commission charged with every buy or sell order you place. Plus most brokerages require you to hold an ETF for a certain number of days or they charge a fee.
While there are commission-free ETFs available, do make sure to check their expense ratios (more on this in a second). Some funds have higher expenses to make up for not charging a commission.
You Contribute $500 Every Other Week for a 10 Year Period to both a Mutual Fund and an ETF
Both Types of Investment Earn an 8% Annual Return
Fees Incurred over the 10 Year Investment Period
- Yearly investment of $13,000 for a total of $130,000
- Many mutual funds have no transaction fees and no sales commissions
- However, just because mutual funds do not have transaction fees or sales commissions, they often do carry other types of fees (redemption fee, account fee, etc), as well as carry an expense ratio in order to pay the broker for actively managing the fund
Exchange-Traded Funds (ETFs):
- Yearly investment of $13,000 for a total of $130,000
- Standard ETF commission of $1 per 1% of return each time a contribution is made. This amounts to $8 each time you contribute.
- You make 26 contributions per year X 10 years for a total of 260 fees charged … just to put money into the ETF.
- After 10 years of making consistent contributions, you would have paid $2,080 in commission for the ETF. That’s $2,000+ you wouldn’t have paid for a mutual fund.
3. TAX EFFICIENCY
While Mutual Funds are great when it comes to not paying commission fees (among other pros stated above), they’re not as great when it comes to tax efficiency.
Mutual funds can expose you to a higher tax bill than ETFs. If the growth strategy behind a fund requires frequent trading (buying and selling) of the stocks, any taxes incurred by the sale of the shares are paid by the shareholder at the end of the year.
ETFs on the other hand, are structured in a way that taxes are minimized for the ETF holder and the ultimate tax bill is less than what the investor would have to pay with a similarly structured mutual fund. This holds true even after an ETF is sold and capital gains tax has been determined.
4. EXPENSE RATIOS
An expense ratio measures how much of a fund’s assets are used for operating expenses. The Expense Ratio is determined by dividing a fund’s operating costs by the total fund assets.
If an ETF carries an expense ratio of .05%, the investor pays $.5 per year for ever $1,000 invested. ETFs have relatively inexpensive expense ratios, some even as low as .03%, compared to mutual funds. This is due in part because a lot of mutual funds are actively managed.
As always, there are exceptions to generalized statements, so research before you invest.
5. INVESTMENT MINIMUMS
Mutual funds have a higher ‘cost of entry’ than ETFs. Mutual funds often have a minimum entry requirement of $1,000 or more. ETFs on the other hand can be bought by the share, so if you only have enough money for one $13 share, that’s fine. This lowers the cost of establishing a position and being able to add to it. Always keep in mind that ETFs are subject to trading commissions and fees whereas Mutual Funds are not.
Key Things to Remember About Mutual Funds
- Mutual Funds have been around longer than ETFs so there are more options to choose from.
- Mutual Funds only have one price each day and
- Mutual Funds offer automatic investments and rebalances, leaving all the hard work up to the fund manager.
- Mutual Funds are not as tax-efficient as ETFs
- Mutual Funds usually have a flat dollar amount for minimum investments.
If you select Mutual Funds that align with your risk tolerance level, give you broad diversity, and don’t charge more than you are comfortable spending; mutual funds are a great long-term, low-cost investment.
Key Things to Remember About ETFs
Despite the exponential growth ETFs have made over the past decade, the number of ETFs available pales in comparison to mutual funds. TD Ameritrade has more than 4,000 transaction-fee- free mutual funds and only 300 commission-free ETFs.
- ETFs have a better tax efficiency than a mutual fund,
- ETFs have lower investment minimums because you can purchase by the share rather than a flat dollar amount
- ETFs charge commissions which make frequent buying and selling expensive
- ETFs cannot make automatic investments
- With ETFs, the investor has the duty of rebalancing their portfolio or outsourcing to a financial advisor.
- ETF prices fluctuate throughout the day because they are traded like stocks. The investor’s specific needs and willingness to monitor price fluctuations while not reacting impulsively should be taken into account.
Whether you choose an ETF or a Mutual Fund is a personal preference. Both are excellent low-cost, long term investments. You might even choose to invest in both.
The most important thing with Mutual Funds and ETFs (and any investments you make) is to do your research before you buy-in. Make sure your hard-earned money is going to an investment that is worth it, that won’t cause you undue stress when the market takes a downturn – which it probably will – and will give you a healthy return when the market takes an upswing (it will).
As reputable financial advisors will tell you, everything fluctuates; the secret to financial success is to never react impulsively.
If you would like more in-depth advice or if you would like for someone to help you manage your accounts, please give us a call or schedule a Get Acquainted Meeting. We would love to hear from you!
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Scott Hamilton is the founder and chief financial officer at Hamilton Financial Planning, a wealth management firm that specializes in providing comprehensive financial planning for retirees in Dallas, Houston, and Austin, Texas. With over 20 years of experience in the financial industry, and has completed over 250 financial plans for retirees across all industries, but mostly the oil and gas industry, Scott is passionate about providing his clients with the tools and insight they need to achieve their financial goals.
He has a Bachelor of Business Administration in finance from Texas State University and an MBA in international finance from Pepperdine University. Scott has also been happily married to his wife, Gayle, for over 25 years. To learn more about Scott, connect with him on LinkedIn.