When you invest in a fund, you pool your money with other investors in order to purchase a collection of securities. This provides opportunities for more diversification—without the hassle of buying and managing individual securities on your own. It’s therefore no surprise that funds are a popular investment option. When investing in funds, the biggest choice you typically have to make is choosing between the two major types of funds: ETFs and mutual funds.
If you’re uncertain about which type of fund is right for you, understanding the pros and cons of each can help you make a more informed decision. In this post, we’ll help you to better understand each of these investment options.
ETFs typically track an index, but ETFs are not the same as index funds. What makes ETFs unique is that they can be traded throughout the day, just like a stock. The price of an ETF is based on supply and demand. This is not the case for mutual funds. Mutual funds are both priced and traded at the end of the trading day. Even though ETFs can be traded throughout the day, you’re usually required to hold ETFs for a certain amount of time or pay a penalty. This means ETFs are not ideal for day traders.
The downside to trading throughout the day is that every time you buy or sell, commission costs come into play—though this has recently become less of a concern. In October of 2019, several major brokerages began eliminating commission fees. In order to remain competitive, most other major brokerages followed suit. No commission fees may make ETFs more attractive, but not all ETFs are free of commission fees, so you should still take the time to check.
Mutual funds also have fees to consider before making your investment. Two common expenses for mutual funds include sales charges (aka broker’s fees) and an annual fee. Before deciding to invest, ensure you are aware of any fees that may be involved. While not every mutual fund will have a broker’s fee, they do all include an annual fee. For mutual funds that include a broker’s fee, the fee may be either a front-end fee (expensed at purchase) or back-end fee (expensed when sold). Your fund may also have other fees. Your advisor can help you to understand the fees associated with your potential investments.
Typically, mutual funds are actively managed, while ETFs are passively managed. With an actively managed fund, a manager is attempting to beat the market. Passively managed funds will usually track an index, such as the S&P 500. The goal of a passively managed fund is to match the performance of the index, as opposed to beating it. It’s worth noting that there are some actively managed ETFs, though these usually have higher fees.
Though ETFs have been around for over 25 years, they’ve seen a massive gain in popularity in the last 15 years or so, thanks at least in part to their popularity among robo advisers. This surge in popularity has led to the creation of thousands of ETFs, but there are still far fewer ETF options than there are mutual funds. While most investors can likely find an ETF that meets their needs, the fact that there are so many fewer options could be considered a disadvantage.
One of the biggest advantages of ETFs is that they tend to have much lower expense ratios, which is how much you pay to own a fund, as a percentage of the amount you invested in that fund. The inexpensive nature of ETFs is one of their biggest advantages and has been a major contributor to their recent popularity.
When comparing any investment options, taxes should always be a consideration. The tax implications of an investment are especially important if the investment is held within a taxable account, as opposed to certain retirement accounts, such as an IRA or 401(k), which are tax advantaged.
As a general rule, ETFs tend to be more tax efficient than mutual funds. This is because of how ETFs are managed. The two primary factors at play here are capital gains tax and the structure of the fund. Here’s what you need to know:
- Capital Gains Tax. Capital gains tax is the tax that the government takes from the sale of your asset, in this case a holding. The tax rate, however, changes depending on how long the investor holds the security. If the security was held for less than a year before the sale, the capital gains tax is equal to the investor’s income tax rate. But if the security was held for longer than a year, a long-term capital gains rate is used, which is typically less than the standard income tax rate (though is still based on the investor’s income tax bracket). Because securities within mutual funds are often traded more frequently than ETFs, you may be taxed at a higher rate than an ETF, which is passively managed and does not trade individual securities as often. ETFs are still subject to capital gains tax, but you will be taxed a lower rate for sold securities that were held for longer than a year.
- Fund Structure. Mutual funds are taxed annually, while ETFs are only taxed when the entire fund is sold. For ETF investors, this can provide greater control, allowing you to choose when to subject yourself to the capital gains tax. Mutual fund investors, however, are taxed annually for the sale of individual securities within the fund, regardless of whether the entire fund was sold or not.
Cost of Entry
One of the biggest advantages of any kind of fund is that it allows an investor to create a far more diversified account with smaller sums. While mutual funds still allow investors to create a diversified portfolio at a fraction of the cost of purchasing individual stocks, the investment minimums can be much higher than with ETFs. Even mutual funds targeted at beginner investors, for instance, can have minimums of up to $1,000 dollars. On the other hand, you can purchase an ETF by the share, which means the barrier to entry can be far lower for ETFs than for mutual funds.
Which is Right for You?
ETFs and mutual funds may both have a place in your portfolio. Depending on your needs, each type of fund may have an advantage or a disadvantage. You should always review the costs, tax structure and management style to ensure the investment is suitable for your financial goal.
If you’re still unsure if ETFs or mutual funds are better for you, consider working with a financial advisor, who can provide personalized advice for your unique situation. Contact The Templeton Group at Cornerstone Financial Management for assistance with your financial plan today.