Vehicle Selection: Mutual Funds vs. ETFs
When It Comes to Investments, Vehicle Selection Matters
How so? So, there are mutual funds and exchange traded funds; many people are confused and believe they are the same form of investment because they are both baskets of investments.
What is a Mutual Fund?
Mutual funds invest in a variety of assets, the majority of which are stocks and bonds. Some mutual funds only invest in specific types of investments, such as equities from specific countries, stocks from companies in a specific industry, or government bonds. Other mutual funds offer various stock and bond portfolios that can help you achieve your financial goals, whether they be for growth, security, or income.
Benefits of Mutual Funds:
When you buy mutual fund shares, your money is added to an already-invested pool. Most mutual funds let you buy stocks and bonds from a wide range of companies.
Younger investors may benefit from a growth fund with more shares since they can ride out market fluctuations. Older investors may choose an income-focused bond fund. Some mutual funds are index-based, while others are human-managed. This makes their costs a bit higher, but you get the benefit of knowing a professional manager will determine which stocks or bonds to hold.
What is an ETF?
ETFs, like mutual funds, are investment vehicles that hold a diverse range of assets and trade on stock markets. These are often broad-based stock and bond solutions based on stock or bond indexes, although they can also be actively managed. ETFs allow you to buy one thing and gain access to a diverse portfolio of equities or bonds.
Benefits of ETFs:
ETFs are typically managed by a computer algorithm that monitors the performance of the market or sector on which the fund is focused. ETFs are typically managed passively, which means that managers do not try to choose winners and beat the market. This is because ETFs tend to replicate market performance. Management fees and expenditures for investors are frequently cheap, as low as 0.25 percent of your investment, making ETFs a terrific choice. If you're new to investing yet want a diverse portfolio, an ETF could be a smart option!
What Do They Have In Common?
Most ETFs and mutual funds follow a given market or sector and have a variety of investments in it. They allow a single investor to own shares in several firms, invest in companies from a particular country, or invest in companies that promote a good cause.
Takeaway: Whether you buy a mutual fund or an exchange-traded fund (ETF), you can invest in a wide range of assets.
What's the difference between ETFs and Mutual Funds?
You will notice there is a big difference, why they are not equal! This is as a result of the different tax structures that apply to these two vehicles.
An ETF trades like a stock because it is basically bundled together and locked in. Whereas, mutual funds are more open and only trade once a day, so you can't just buy and sell them on a stock exchange. Those two different structures have some massive impacts.
The Chartered Financial Analyst Institute actually conducted a study and discovered that mutual funds have a substantially greater cost than ETFs or that mutual funds in general have a higher cost. You have the expense ratio and the turnover drag, which means that buying and selling different equities causes drag and costs. There are tax costs and cash costs built in there. Every mutual fund has to have a certain amount of cash on hand to be able to fund and liquidate different investments, anytime money goes in and out. Those costs really add up. So, in a taxable account, which is where you really get hit with taxes! The costs are about 4.17%. 4.17% is your cost of owning a mutual fund.
For instance: If you have a stock mutual fund, on average it will give you a return of 9% per year. That costs 4.17%, which brings you down to just under five. A big part of that return will be inflation. Let's say the inflation rate was 2%. Well, now you're only making 3%, so you can see how these costs eat away at your profits. Not only is it the cost of managing investments, but also the cost of the whole structure. If it is a net tax-protected account, the costs are closer to 3.17 percent, which is still a lot! Even if the mutual funds are in a retirement account like a 401k or IRA, these costs still add up over time.
Active Management vs. Passive Management
How a fund invests affects its costs and profits. Some funds use "active management," which means the manager determines when to acquire and sell equities. Mutual funds usually work this way.
- Passive investing means the fund management doesn't pick the investments. Instead, they copy an index like the S&P 500. ETFs are more often actively managed, but they can also be passive.
- Mutual funds are actively managed, while ETFs are passive. But these lines aren't as clear-cut as they used to be, and now you can find both actively managed ETFs and passively managed mutual funds.
This difference is important for two main reasons:
1. The returns you can expect as an investor and;
2. How much you can expect to pay in fees.
Fund returns and costs
The bottom line of the active vs. passive debate is that most of the time, passive investing is better. Yes, the best funds can beat their benchmarks, but it is hard for active managers to beat their benchmarks over time.
The goal of passive investing is not to beat the market, which is what most active managers try to do. Passive investors, on the other hand, just want to be the market. And if passive investing does better than most investors, that means you can do better than most active professional managers. That gives an advantage to ETFs, which are usually managed passively, though some mutual funds are also managed passively.
Another problem with active management is that it usually costs more than a fund that is managed passively. The lower costs of ETFs have helped lower the costs of mutual funds.
As the chart below shows, fund expenses have been going down for the past 20 years. Whether you look at a simple average or an asset-weighted average, the costs of stock mutual funds are still higher than those of ETFs (factoring in how big the fund is).
The asset-weighted average tells you what a typical investor could actually be paying, whereas the simple average provides you an estimate of what you would spend if you randomly selected funds. Accordingly, when comparing their respective average costs, mutual funds are significantly more expensive than ETFs.
For instance, an asset-weighted average mutual fund would cost 0.50 percent of your assets annually in 2020. In actuality, you would incur a $50 expense for every $10,000 you invested. For every $10,000 invested, the equivalent average ETF has a cost ratio of just 0.18 percent, or $18 yearly. When you go further, the specifics change. As shown in the chart below, if you concentrate on passively managed stock mutual funds, they are actually less expensive than passively managed stock ETFs.
In 2020, stock index mutual funds assessed an average fee of 0.06 percent (asset-weighted), compared to a 0.18 percent fee for a stock index ETF.
Another way that an actively managed mutual fund could hurt your returns is by raising your tax liability. An actively managed fund, such as most ETFs, realizes capital gains more frequently than a passively managed fund since it trades in and out of the market. At the end of the year, it must distribute some of those taxable capital gains to investors. Investors in mutual funds may also need to be aware of sales commissions, which can quickly deplete your principal before you have even made an investment. That is not an expense related to ETFs. Check the expense ratio and any other fund fees before investing, whether you choose an ETF or mutual fund. Focus first on costs because they are a significant determinant of return, particularly for index funds since everyone is already monitoring the same benchmark.
When Mutual Funds and ETFs can be Purchased?
The window for buying an ETF or mutual fund varies. The only time mutual funds are valued is at the close of each trading day. You can place your order at any time, but it will not be filled until the final tally of the day's funds is made. Therefore, you would not be aware of your payment until the transaction is over. However, you will always be required to pay the fund's holdings' actual net asset value.
An ETF, on the other hand, can be purchased whenever the market is open and trades on an exchange like a stock. In the same way that you would for a stock, you may make a buy or sell order and see the precise price you will pay when the order is carried out. In contrast to a mutual fund, you could pay more or less than the actual net assets of the fund, but the difference is typically insignificant.
Due to their trading flexibility, ETFs are a well-liked investment vehicle!
Which Should You Choose—ETFs or Mutual Funds—and Why?
Since mutual funds and ETFs function similarly in many respects, the best long-term decision mostly depends on the fund's actual investments (the types of stocks and bonds, for example). For instance, the performance of mutual funds and ETFs based on the S&P 500 index will be basically the same for you. However, the way in which actively managed funds are invested can have a significant impact on the outcomes.
However, the discrepancies are found in the fees, commissions, and other expenses related to your selection. An ETF outperforms mutual funds in these areas. Additionally, they have an advantage in terms of tax efficiency, which lowers your entire tax burden.
Do ETFs and mutual funds pay distributions?
Mutual funds pay distributions at year's end, while ETFs pay dividends throughout. But there’s a difference in these payouts to investors, and ETF investors have an advantage here, too. ETFs pay quarterly dividends. The more shares you own, the bigger your total payout. Not all funds that pay out cash offer dividends. Fixed-income ETFs pay interest. ETF distributions can be either qualified or non-qualified. The difference is how they are taxed and how long the ETF stock is held.
- Qualified dividends are paid on stock held by the ETF.
- The share must be held for more than 60 days in the 121 days before the ex-dividend date.
- Dividends are taxed as capital gains.
Ordinary income tax rates apply to non-qualified dividends.
Mutual funds may pay out either regularly or as a lump payment at the end of the year. Investors may also be able to use the regulations surrounding qualifying dividends to obtain a lower tax rate on distributions. However, mutual funds may expose investors to an additional tax difficulty. This is due to the fact that mutual funds must share their realized capital gains at the end of the year. While you may receive the payment in cash, you may be required to pay taxes on it to the IRS. Mutual funds maintained in tax-advantaged accounts are exempt from these tax considerations.
Even if the mutual fund isn't actively trading stocks, redeeming shares for departing investors can cause management to sell investments, resulting in a financial gain. If you buy the fund late in the year, you may owe taxes on events before you invested.
Compared to ETFs, are Mutual Funds Safer?
The way they are structured, neither the mutual fund nor the ETF is more secure than the other. What the fund itself owns determines how safe a position is. Bonds are typically less risky than stocks, while corporate bonds are slightly riskier than U.S. government bonds. Higher risk, however, may result in higher long-term returns (particularly if it is diversified).
Therefore, it is important that you comprehend the features of your investments, in addition to whether they are mutual or ETF funds. You would not be exposed to greater risk one way or the other because a mutual fund or exchange-traded fund (ETF) tracking the same index will produce roughly the same returns.
An ETF is a superior choice for investors for many different uses because it comes with some tax benefits, low commissions, and simple trading. However, in some situations, particularly for stock index funds, mutual funds might be more affordable than ETFs. Additionally, if they are held in a tax-advantaged account, their tax implications are also immaterial. In either case, you need to be aware of your investments and how they support your financial objectives.
Hopefully, you found this information to be beneficial! If you have any questions, please feel free to reach out here. We are always here to help!