Mutual funds have long-been the natural go-to for investors looking for an easy way to create a well-diversified portfolio. While it’s true that mutual funds have some significant upsides, they aren’t without limitations (i.e. fees, minimums, and limited liquidity). While not deal breakers for every investor, these limitations are no doubt part of the reason that more and more people are turning to Exchange Traded Funds (ETFs).
Introduced in 1993, worldwide ETF assets now exceed $1.5 trillion. Much of the appeal comes from that fact that ETFs combine the simplicity of mutual funds with the flexibility of individual stocks.
In a nutshell, an ETF is a portfolio of stocks, bonds, or other investments that trades on a stock exchange. ETFs can be crafted to be extremely narrowly focused (i.e. representative of a specific sector such as oil or gold) or very broad (i.e. representative of the entire S&P index).
ETFs possess numerous advantages over traditional, actively managed mutual funds. For starters, ETFs are very inexpensive. Both ETFs and mutual funds have internal charges that the sponsoring firm charges. However, the fees associated with ETFs can be up to three times less. Reducing internal costs, especially to this degree, provides investors with a significant starting advantage.
Secondly, compared to mutual funds ETFs are tax efficient. Here’s why: if held in a taxable account, traditional mutual funds tend to generate capital gains through turnover. That capital gains then gets passed on to shareholders in the form of an annual tax bill. ETFs, on the other hand, typically have very little to no turnover, significantly decreasing or eliminating the tax bills.
Another unique aspect of ETFs is that, like stocks, they are priced throughout the day whereas mutual funds only get priced once, after the close of the market close. Does this really make a difference? Absolutely. With ETFs you now know exactly at what price you are buying or selling at any given moment. If you want to buy at a particular price a specific order can be created. That type of precision pricing and buying simply isn’t an option with mutual funds.
Similarly, ETFs disclose their holdings every day. If knowing what you own is important, and it should be ETFs hold a clear advantage over mutual funds that only have to disclose their holdings twice a year.
But forgetting flexibility, reporting, etc., the real question for investors is this: which performs better? ETFs or mutual funds?
Obviously, if the answer to that was crystal clear there’d be no need for the one that lags behind. What is clear is that mutual funds have to perform significantly better than ETFs in order to erase the expense of their associated fees.
Like all investments ETFs aren’t without risk. Before making any investment do your homework; read the prospectus and make sure you understand the pros, cons, and risks. If you aren’t already familiar with Exchange Traded Funds take some time to get online to do some research or ask your advisor for some help.