Imagine yourself in a room crowded with all the potential investments you could make to fill out your portfolio. Your gaze goes to the other side of the room, your attention drawn by two investment possibilities: mutual funds and exchange traded funds (ETFs). From a distance, they’re looking pretty good.
But you’re a savvy investor who doesn’t rush into an investment without looking a bit deeper into the investing opportunities before taking the plunge. You’re planning your retirement, not just looking for a quick payday. A comparison of the pros and cons of mutual funds versus ETFs is needed before investment dollars are actually spent.
How a mutual fund works
A mutual fund is a pool of money from investors all making different types of investments, such as money market funds, stocks and bonds. These investors are all hoping to make a nice pile of money off their collection of investments, which they call their portfolio.
The person, or team of people, overseeing the mutual fund is the professional investment manager. They watch the markets, buying and selling securities so as to reap the most money for the fund.
As an investor, you’re a shareholder in the mutual fund. When the fund profits, you get paid dividends. If the fund loses money, the value of your investment decreases, so you lose money.
How an ETF works
Exchange traded funds (ETFs) were developed in the early 1990s. Like mutual funds, ETFs are a combination of lots of different investment assets. The shares in an ETF are traded on the open stock market, however. This gives individual shareholders more flexibility, allowing them to follow the markets and react to changes virtually in real time.
Fees…there are always fees…
We all understand that nothing in life is free; that includes managers for mutual funds and ETFs. Mutual funds usually charge a percentage as the management fee. If you’re investing in special or international mutual funds, there may be additional charges. There may be an additional management fee charged by brokers, bankers or various advisers who have a hand in overseeing the mutual fund portfolio.
ETFs are usually less costly because they don’t generate sales commissions and are less expensive to oversee. This translates to lower management fees goings to advisers.
The left hand may not know what the right hand is doing
One of the big buzz-words in today’s social nomenclature is “transparency.” Everybody wants everything to be out in the open and visible for all to see. That isn’t the way mutual funds work, however. Transparency usually isn’t high on the priority list in the mutual fund industry. Because of this, you may actually be invested in different mutual funds that are actually holding some of the same stocks. That makes you’re overexposed to the risks in single companies.
ETFs tend to be more simplistic and are therefore far more transparent. When you’re invested in an ETF, you essentially own various different market indexes. You don’t have the risk of being overexposed to a single entity. The way ETFs are set up has more specificity built in so your investments don’t overlap.
Don’t ignore the tax man
If you’re planning retirement with mutual funds as your investment vehicle, you won’t have much control over your gains or losses. That means you don’t have much control over the taxes for which you’ll be liable. At the end of the day, there is simply no denying that mutual funds are not known for being tax-efficient investments.
ETFs follow an index; this makes them, by design, far more tax-efficient. You as the investor have far more control over when you take gains or losses. Because ETFs trade like stocks, you can know at exactly what price you bought or sold assets. With a little math, you can figure out what your tax burden is looking like at any time and respond accordingly.
With a mutual fund, you’re probably going to have to meet an investment minimum. This is usually not a big deal to most investors but it does limit how far you can spread out your risk and the different options available to you.
With an ETF, an investment minimum is rarely required. This makes investing in an ETF far more accessible. Even if all you can afford to buy is one share, you can get involved in the ETF. This also allows those managing the ETF to greatly increase the diversification of your investments. That gives your money an improved chance of turning a profit for you.
And profit is the name of the game.