What’s the difference: ETF vs mutual funds? Exchange-traded funds and mutual funds are two avenues chosen by some investors to pursue diversification. Learn more here.
If you’re like many investors saving for retirement or another goal, you’ve heard about portfolio diversification. “Don’t put all your eggs in one basket” is among the most common pieces of wisdom dispensed to investors.
Two typical avenues investors might use for diversification are mutual funds and exchange-traded funds (ETFs). When making a comparison of ETFs vs. mutual funds, it's important to note that ETFs and mutual funds are similar in that both represent a professionally managed “basket” of securities, typically stocks and bonds. Yet they're structured differently.
Most, though not all ETFs feature a "passive" management approach and most, though not all mutual funds feature an "active" management approach; the expense ratios respective to both instruments may also vary; and the features and functionalities that make either instrument a good match for an individual investor is contingent upon the investor’s financial goals, resources and individual investing preferences.
For investors trying to decide whether mutual funds or ETFs are the right choice, it helps to delve a bit deeper in how they compare and contrast. First, let's look at the landscape, which has changed dramatically over the last 25 years.
An ETF is a single security that typically tracks an index or portfolio, or seeks to target their performance. ETFs burst onto the financial scene in 1993. Over the last decade, there's been a tremendous rise in the number of ETF products, as well as the amount of assets held in ETFs. More employers now offer access to them as part of their retirement packages along with mutual funds, and retail investors trade them with increasing regularity. Many financial pundits tout their functionalities as if these products somehow constituted an “evolutionary” step in the fund space.
According to data compiled by the Investment Company Institute (ICI), the number of distinct ETF product offerings nearly tripled from 2007 to 2016. In that same period, inflows for ETFs increased from $600 billion to $2.5 trillion. Mutual fund investments had been growing steadily through the decades, but lately have experienced outflows. In terms of total assets held, however, mutual funds still dominate the landscape. According to the ICI's 2017 Handbook, U.S. investors held $16.34 trillion in mutual funds as of the end of 2016.
Let’s start with a basic comparison. Take a look at the table below.
So, what might these features (or lack thereof) mean for you as an investor? In other words, what could they help you accomplish, and what demands or limitations might they place on you as an individual investor?
To answer these questions, here’s a brief summary of some of the pros and cons of exchange-traded funds vs. mutual funds.
Potential Pros of Owning ETFs
With ETFs, you can trade more flexibly, as these products are traded intraday. Your minimum investment requirements are generally lower than mutual funds. Daily holding disclosures make ETF investing more transparent. And finally, unless you're invested in mutual funds through an IRA plan, ETFs might be more tax efficient, as you're generally required to pay taxes only on closed positions that realize capital gains, whereas (non-IRA) mutual fund holders may be subject to taxable events when fund managers realize gains in the course of rebalancing a portfolio by turning over assets. A 2016 study by S&P Dow Jones Indices found that over the past 15 years, 92.15% of large-cap managers, 95.4% of mid-cap managers, and 93.21% of small-cap managers trailed their respective benchmarks. Some might conclude, then, that a "passive" investing model that invests in funds that target an index might be an appropriate strategy.
Although ETFs are professionally managed, they do not offer the same level of “active management” as mutual funds. As a self-directed ETF investor, you might need to take a more active role in monitoring, reviewing and potentially rebalancing your portfolio. This self-directed approach might require additional time and effort. Also, if you plan to actively trade the assets in your account, or if you plan to make incremental additions to your ETF holdings, remember that multiple trades can mean multiple transaction costs.
If you prefer to invest in a fund that offers a more hands-on approach to allocating and rebalancing your assets in light of longer-term economic opportunities and risks, then you might want to take a closer look at a service that allocates and rebalances a portfolio of ETFs for you, such as Essential Portfolios, from TD Ameritrade Investment Management, LLC.*
Mutual Fund Pros
With mutual funds, you have the option of investing in passively managed and actively managed funds. Passive funds are similar to most ETFs in that they track a specific benchmark such as the S&P 500 index. But only through mutual funds can you benefit from a professional fund manager’s efforts in actively balancing and rebalancing your portfolio in response to big-picture economic fundamentals. This in itself is a major advantage offered by mutual funds; one that is largely absent in ETFs and one that may be highly suitable to investors who prefer a more hands-off approach to investing.
Good fund managers know the “ins and outs” of portfolio construction. They understand the intricacies of particular sectors in relation to the wider economic landscape, and they’re seasoned market participants who probably have weathered several market downturns and other unfavorable economic conditions in pursuit of overlooked and undervalued assets. Although mutual funds might not have the “intraday” trading convenience of an ETF, as funds are purchased or “redeemed” end-of-day (EOD) either directly through the fund’s issuing company or through a broker, mutual funds nevertheless offer the convenience of direct automatic deposits; a feature that ETFs do not offer.
Mutual Fund Cons
Some mutual funds have high asset turnovers, which can mean more transaction costs and a larger capital gains tax bill. Fund managers report their holdings quarterly or semiannually; this means that you won’t always know the details or frequency of each transaction. And finally, mutual fund holders may also be required to pay 12b-1 fees: annual marketing and distribution fees that are part of a fund’s operating expenses. Bear in mind that these “expense ratios” are characteristic of both products, mutual funds and ETFs. And some mutual funds may come with higher or lower expense ratios than other funds or ETFs. So be sure to read a fund’s prospectus carefully to determine whether its strategy and costs may be suitable to your investment goals.
In short, both products come with their own set of advantages and disadvantages.
But which product—mutual funds or ETFs—might better serve your financial goals, match your risk tolerance, or align with your investment style? Ultimately, it depends on the kind of investor you are.
How actively do you plan to invest? How much time are you willing to spend on monitoring your portfolio? How much effort do you want to put into enhancing your investing acumen? Let these answers guide you as you compare ETFs vs. mutual funds.
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