All About Exchange-Traded Funds or ETFs! (vs. Mutual Funds)
By: Bob Anderberg
Exchange-Traded Funds (ETFs) vs Mutual Funds — which one is right for you?
If you have a 401(k) plan, a related employer-sponsored retirement plan, or an Individual Retirement Account (IRA) of your own, it’s highly likely that you have heard of mutual funds. But do you know how a mutual fund differs from an ETF?
For years mutual funds have been used to create an affordable diversified portfolio through the expertise of “open-end” investment companies that create a “basket of investments” that can be purchased as shares of mutual funds.
But what about the relatively new investment vehicles called Exchange Traded Funds (ETFs)? What are the advantages and disadvantages of ETFs compared to Mutual Funds? Today we dive into the ETF.
The ETF: Newer and Leaner!
While U.S. Mutual Funds have been around since 1924, the first ETF to be traded in happened in 1993. ETFs are famous for holding a “basket of investments” that tracks an index like the S&P 500 and follow the philosophy of passive investing, where you let your portfolio track an index(es) and don’t worry about trying to “beat the market,” which over the long haul has been shown to be very difficult.
Mutual Funds . . . close at the end of the trading day, while ETFs are exchanged on the open market by buyers and sellers.
By tracking an index, these ETFs have very low management fees, and do not charge the sales load charges that mutual funds do. A big difference between mutual funds and ETFs is that the mutual funds are redeemed by the mutual fund company at the NAV (net asset value) the fund closes at the end of the trading day, while ETFs are exchanged on the open market by buyers and sellers, which means that they may trade at a slight premium or discount on the NAV of the fund.
Advantages of an ETF—Usually Better for Taxes!
One characteristic of a mutual fund is it can kick out capital gains and dividends. This happens when the companies owned in the fund pay dividends, or the company is forced to liquidate shares of certain companies in the fund to maintain their intended allocations, among other things.
Even if you choose to have these distributions reinvested in the fund, it can still create a tax headache if the mutual funds are held outside of a qualified account like an IRA or a 401(k) plan.
The ETFs generally do not generate as many capital gains because of a unique creation/redemption process, which allows them to avoid selling fund holdings that create capital gains. In addition, the passive nature of many of the funds creates a lower trading frequency unless the underlying index also changes, resulting in fewer Capital gains.
Some Drawbacks for ETFs, and food for thought . . .
Some disadvantages of trading on the open market are the price volatility that you might encounter by having to pay a slight premium to purchase an ETF, as there is a bid (buyer’s offer) and asking (seller’s offer) price, meaning the parties involved must agree on a price.
Conversely, if you are wanting to sell an ETF in a down market, you may have to sell at a slight discount!
These premiums and discounts can be magnified in volatile markets, and we have seen a lot of volatility lately!
In contrast, with mutual funds, the sponsoring company is always obligated to buy the fund at NAV priced at the end of the trading day, so there is an element of price stability there. Some mutual funds may be more attractive to active-trading strategies with more specialized or niche investment strategies designed to capitalize on an inefficient market, although there are specialized sector and thematic ETFs emerging that also work in this space. Finally, your advisor may charge a trading fee to buy and sell ETFs, which you will want to check before engaging in trading.
At the end of the day, both Mutual Funds and ETFs provide good options for both amateur and advanced investors!
Both mutual funds and ETFs have taken steps to stay competitive with each other. Many mutual funds offer lower sales loads or waive them altogether and offer passive investment options that rival the low cost of ETFs. Some also offer tax-managed investment strategies designed to minimize capital gains.
ETFs have also started to offer specialized investment themes and have managers employing active investment strategies like mutual funds.
Need help navigating which mutual funds or ETFs are right for you?
To help navigate which investment vehicles are right for you, a financial advisor can help you come up with solid investment options which match your needs. For more information on how we can help you please visit us at our website, or schedule a free consultation.
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