The Benefits of ETFs Versus Mutual Funds For Your Portfolio: Why ETFs may be a better fit for your portfolio
Investors make choices every day.
Real estate vs. equities.
Stocks vs Bonds.
Value funds vs. growth funds.
ETFs vs. Mutual funds.
While it may not seem like it, ETFs or exchange-traded funds are relative newcomers to the investing world. They first appeared on the U.S. market in the early 1990s and then took off with a bang. Today, they are one of the most popular investment vehicles for investors.
Over the past two decades, ETFs have begun a rivalry with traditional mutual funds. Consequently, many investors have been left confused trying to understand the difference and the best way forward.
Do you know if ETFs or mutual funds are better for your portfolio?
Let's take a look.
First, remember a fundamental rule of investing — don’t invest in something you don’t understand. Don't just do it because your wealth manager says it's a good idea, because you read about it on the internet, or (worse) because everyone else is sinking money into it.
Instead, take the time to understand why it’s right for you. Don't shy away from asking your advisor questions when you have them. When it comes to being confident about your investment strategy, asking questions can be a good thing.
Let's look at what you need to know if you're considering investing in an ETF. That way, you can make your own decision about how to move forward.
What are Exchange-Traded Funds (ETFs)?
ETFs are a hybrid between a stock and a mutual fund. They are funds traded on a stock exchange, and they generally track an underlying index or sector, such as the S&P 500 or the Dow Jones Industrial Average. That means they will aim to mirror the prices and returns of the index.
Here's an example:
If you buy into an S&P 500 ETF and the S&P 500 index goes up, so should your ETF. If it drops, then your ETF would follow the index downward.
Like a traditional mutual fund, an ETF holds a portfolio of investments including stocks, bonds, and occasionally a commodity like oil or a precious metal such as gold. An ETF can even hold a portfolio of stocks from a single sector such as technology, pharmaceuticals, or real estate.
ETFs come in several major types, including market ETFs, bond ETFs, commodity ETFs, actively managed, and even alternative investment ETFs. While they invest in different assets and may operate differently, all ETFs share the same basic structure.
How are ETFs Different from Traditional Mutual Funds?
If it sounds like ETFs are a lot like traditional mutual funds, that's because they are. Before you invest, however, it's important to know the key differences that separate the two.
First, they are bought differently. ETFs are bought and sold throughout the day. Mutual funds are bought and sold once a day after the market closes.
As it relates to tax efficiency and capital gain distributions, most — though not all ETFs — follow the market index, and most — though not all — mutual funds are actively trying to outperform the market.
The History Behind ETFs
Wells Fargo and American National Bank launched the first index mutual funds in 1973, but these were only for institutional investors. Individuals couldn't buy them until 1975 when the Vanguard 500 Index Fund appeared on the market. These were similar to but not exactly the same as the ETFs we trade today.
Modern ETFs didn't come into existence in the U.S. until January 23, 1993. The very first ETF was called the S&P 500 SPDR, and it still exists today. In fact, it manages about $328 billion in assets and trades for approximately $430.
The idea of a fund traded on the stock exchange proved popular with investors, and by 2009, nearly 1,000 ETFs were being traded on the market.
Why ETFs are Better Than Traditional Mutual Funds
Some investors prefer ETFs to traditional mutual funds. What are the benefits of ETF investing?
ETFs can be more cost-effective than mutual funds. Mutual funds garner transaction fees, distribution charges, and capital gains taxes, all of which they pass along to their investors. ETFs are not fee-free, but they don't typically cost quite as much as a traditional mutual fund.
ETFs can be more liquid than mutual funds. Because ETFs are traded directly on a stock exchange, you can buy and sell your ETFs throughout the day — although that doesn't mean you get the cash faster. In fact, it's often the opposite as a result of trade settlements, which for ETFs is currently 2 days. The benefit of trading throughout the day can be primarily attractive to larger-scale investors who want to take advantage of quick moves in the market.
Why Traditional Mutual Funds are Better Than ETFs
When you consider the benefits of ETFs, they may look like a better investment than mutual funds. But looks can be deceiving. ETFs may not be the best choice for every investor.
Due to some ETFs' wide bid/ask spreads, you might find yourself buying at the high end and selling at the low end of the spread.
While ETFs are generally passive index funds, mutual funds offer the same market index type investing options, but also offer a wide variety of actively managed options. This can be appealing for an investor who has a more targeted investment goal, or who is looking for a fund that is actively trying to pick the “right” investments and time the market (getting in and out of the market at the “right” time).
Are ETFs Safer Than Mutual Funds?
Nearly all ETFs and mutual funds provide greater diversification than a single stock, but is one more secure than the other?
Not really. At least, neither structure appears safer than the other. It generally comes down to the assets the fund owns and the management of that fund.
Whether it’s an ETF or mutual fund, it’s important to understand the characteristics of that fund before you decide to invest. This includes considering the fund’s objectives and how it can help you achieve your financial goals.
Are ETFs Good for Retirement?
ETFs and mutual funds offer many of the same benefits. Both help diversify your portfolio. Both are professionally managed. And both offer several options.
Both ETFs and mutual funds can be good investment options for retirement, depending on your needs and where you are on your retirement journey. There’s also no reason why you cannot invest in both if they can provide additional diversification to your investment portfolio
To find out what mix of investments can help grow and preserve your nest egg, contact Cooke Wealth Management today. Our Christian wealth management professionals would love to discuss your unique strategy with you.
As with almost all investments, there is risk in both mutual funds and ETFs, and returns are not guaranteed. Consider talking to your financial advisor before investing in any asset.