If you are considering investing, Exchange-Traded Funds (ETFs) and mutual funds are two choices available to investors. And like all investments, ETFs and mutual funds have their own set of pros and cons. Because investing is risky, it is important to understand the pros and cons of all investments, including ETFs and mutual funds. In this blog post, we’ll explore ETF’s vs mutual funds. We’ll review their basics, similarities and differences, and pros and cons to help you decide if these investments align with your financial goals.
ETFs and Mutual Funds Basics
Exchange-Traded Funds (ETFs) and mutual funds are investments that pool money from many investors. The funds have diversified portfolios including stocks and bonds. ETFs are traded on stock exchanges, while mutual funds are managed by professional fund managers. Both ETF’s and mutual funds are known for their accessibility and diversity. When an investor cannot afford the full price of a stock, ETF’s and mutual funds offer partial shares. This aims to make investing in the market more affordable. And while ETF’s and mutual funds have similarities, they also have distinct differences. Before we explore ETF’s vs mutual funds, let’s break down the pros and cons of each investment.
ETF Basics
ETFs are investment funds traded on stock exchanges, like individual stocks. They often track an index, commodity, or a basket of assets. This provides investors with the opportunity to buy or sell throughout the trading day.
Pros of ETFs
Lower Expense Ratios
ETFs typically have lower expense ratios compared to mutual funds. Lower expenses mean investors may keep more of their returns.
Intraday Trading
ETFs offer the flexibility of intraday trading. This allows investors to buy or sell shares at market prices during regular trading hours. Real-time trading gives investors increased control over investment decisions.
Tax Efficiency
ETFs are known for their tax efficiency. Because of their structure, ETF’s often produce fewer capital gains distributions than mutual funds. To help clarify this idea, let’s recall that investors make money in one of three ways, interest, dividends, and capital gains. Capital gains are taxed differently than income. And taxes on capital gains depend on the time you hold your investment. Short-term capital gain investments are held for 364 days or less. And long-term capital gain investments are held for at least 365 days or longer. The tax rate for long-term capital gains is lower than for short-term gains. Each year mutual funds must redeem shares (sell securities) and distribute dividends and capital gains among their investors. This triggers a taxable event. ETF’s do not have to sell securities to meet redemptions. This results in potentially lower tax obligations for investors. ETFs use a special process to create and redeem shares by leveraging an “in-kind” creation and redemption process. This helps minimize the need to distribute capital gains. This tax-efficient structure often appeals to tax-conscious investors.
Cons of ETFs
Limited Investment Strategies
While ETFs offer diversification, some investors may find the investment strategies limited compared to actively managed mutual funds.
Bid-Ask Spreads
In the stock market, the bid price is the highest price a buyer will pay. The ask price is the lowest price a seller will accept. And the difference between the bid and the ask is the spread. The spread is the transaction cost. Each trade incurs a cost. And investors may incur more transaction costs if they trade ETF’s often throughout the day. This frequent trading can reduce overall returns.
Mutual Fund Basics
Mutual funds are investment vehicles where money is pooled from many investors to buy a variety of stocks, bonds, or other securities. A professional fund manager manages the mix of investments. Investors give the fund manager discretionary rights to trade on their behalf. By investing in a mutual fund, individuals gain access to a broad range of investments. This aims to reduce risk compared to investing in a single stock or bond. Investors earn returns based on the fund’s performance minus fees or expenses. In this way, mutual funds can give small or individual investors access to professionally managed portfolios of stocks, bonds, and other asset classes. A mutual fund must trade according to its charter. The charter is a legal document that outlines the fund’s investment objectives, strategies, and limitations. The charter specifies the types of securities the fund can invest in, the level of risk it can take, and the investment goals it seeks to achieve. The charter gives investors a clear understanding of the management of the fund.
Pros of Mutual Funds
Professional Management
Professional fund managers manage mutual funds. These managers analyze market trends and make investment decisions for investors.
Diversification
Mutual funds offer instant diversification by investing in a variety of assets. This diversification may help mitigate risks associated with the performance of individual securities.
Accessibility
A wide range of investors can access mutual funds. This includes investors with limited capital. Accessibility allows smaller investors to take part in a diversified portfolio managed by professionals.
Simplified Investment Process
Mutual funds offer simplicity in their investment structure. Investors can easily buy and sell shares directly through the fund company. The simple process may appeal to investors seeking a straightforward approach to investing.
Diverse Portfolios
While not as inherently diversified as ETFs, mutual funds offer variety of portfolio choices. Investors can choose funds aligned with their risk tolerance and financial goals. Mutual funds also give investors customized strategies tailored to their specific needs.
Cons of Mutual Funds
Higher Expense Ratios
Compared to ETFs, mutual funds often have higher expense ratios. These fees cover the costs of fund management, administration, and marketing. The higher expense ratio may impact overall returns for investors.
Lack of Intraday Trading
Unlike ETFs, mutual funds can only trade after the market closes because they are priced at their net asset value (NAV). The NAV is the difference between the value of the mutual fund’s assets and liabilities. And the NAV is calculated after trading closes. This lack of intraday trading flexibility may be a disadvantage for some investors who want to trade in real-time. This end-of-day redemption also makes mutual funds less flexible than ETFs.
Further Considerations of ETF’s vs Mutual Funds
Historical Performance
Both ETFs and mutual funds have shown varying performance over the years. Historical data aims to help investors analyze past trends to make informed decisions.
Risks and Risk Tolerance
Investors should know of the risks associated with all investments, including ETFs and mutual funds. The risk of losing money, including your initial investment, comes from many sources. Sources of risks of ETF and mutual fund investments may include interest rate and market swings, inflation, geopolitical events, and fund management. Risk tolerance is your comfort level of how much money you are willing to lose. Risk tolerance is unique to each investor. Knowing your risk tolerance before investing will help guide your strategy. Consider speaking with a Financial Advisor to learn about your risk tolerance and the risks of investing.
Investment Goals and Time Horizon
Clear investment goals, whether short-term or long-term, aim to guide investors in choosing the most suitable investment that aligns with their financial objectives. Investment goals often include when you plan to use your money. This is known as the time horizon. For example, saving for retirement typically has a longer time horizon than saving for a house. Knowing your goals and time horizon aims to guide your investment choice of ETFs vs mutual funds.
Trading Options and Accessibility Needs
ETF and mutual funds both offer flexibility. But ETFs offer more trading choices than mutual funds. The intraday trading feature of ETF’s allows for more trading choices like stop and limit orders, and options. Mutual funds only trade after the market closes. They do not offer other trading choices. Assessing your liquidity needs and preferred trading style aims to help guide the choice between the two.
Investment Minimums and Fees
Investment Minimums
Investors can buy ETFs for the price of a single share. But mutual funds often have minimum initial investment requirements, possibly in the thousands.
Fees
Both ETFs and mutual funds charge fees. While ETFs may charge trading commissions and fees their expense ratios are typically lower than mutual funds. Mutual funds often charge sales loads and other fees.
Management Style
Most ETFs are passively managed. This means they track market indexes or sector sub-indexes. Mutual funds are actively or passively managed.
Conclusion
In conclusion, the choice between ETFs vs mutual funds depends on many factors. These include investor preferences, goals, and risk tolerance. Consider speaking with a Financial Advisor and conducting thorough research before investing. While ETFs and mutual funds offer similar features, they have distinct characteristics that may influence your investment decisions. Whether you opt for real-time ETF trading or the professional management of mutual funds, your financial goals will guide you towards unlocking your investment strategy.
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Disclosure:
The use of asset allocation or diversification does not assure a profit or guarantee against a loss. Past performance is not a guarantee of future results. This information is not intended to be used – and cannot be used – to avoid penalties under the Internal Revenue Code.
Georgene Collins, RICP®, RN, PhD, MBA is a registered nurse turned Financial Advisor at Airey Financial Group. Georgene helps other nurses take control of their finances and prepare for retirement. Georgene began her career with Airey Financial Group in 2017 after retiring from 30 years in healthcare.
Georgene holds the Retirement Income Certified Professional (RICP®) designation from The American College of Financial Services. She holds health and life insurance licenses and a long-term care certificate in Indiana, Illinois, and Wisconsin. Georgene is a Registered Representative and Investment Advisor Representative and has earned the FINRA Series 63 and 65 registrations.
