Gym-splain that to me...Mutual Funds vs. ETFs
Mutual funds and Exchange Traded Funds (or ETFs) are two of the most common tools used by everyday investors (you and me) to “simplify” the process of creating a portfolio and keep investment costs low. So what exactly are they? How do they work? Which one is better?
Generally speaking, both mutual funds and ETFs provide the benefit of diversification by giving us the ability to purchase only one investment. How do they do this?
Mutual funds and ETFs are basically basket investments made up of a number of different stocks, bonds, money market funds, or other investments (like commodities or real-estate). You can purchase a single share and instantly own everything in that fund.
Think of these investments as pies. In just one slice of pie, there are a number of individual ingredients...you eat them all. Purchasing one share of a Mutual Fund or ETF allows you to own every stock, bond, or other investment that is held in that basket.
If both types of investments do the same thing, why does it matter which you choose? There are some pretty major differences between the two as far as cost, tax efficiency, and management type are concerned.
Cost: Mutual funds are managed by a team of people. They provide research and make investment decisions on your behalf. As a result, the cost of these funds are higher than their ETF counterparts. ETFs are electronically managed. There may be a team of a few people who oversee the algorithms and watch out for glitches, but they aren’t responsible for executing trades or researching new investment ideas. Mutual funds can also have load fees. These are additional costs that are denoted as either front-end or back-end fees. Think of a front-end fee as admission to get into the club. If you invest $100 in a mutual fund that has a front load of 5%, your first $5 goes towards paying management expenses, meaning you only invest $95. Back-end fees are commission you pay before you walk out the door. If you earn $500 in a fund with a 5% back load, you will pay your sales team $25 and walk away with $475 instead of the full $500.
Tax Efficiency: Ahh taxes, they’re everywhere. Whenever you earn money, whether through your paycheck, rental income, or your investments, the government is always there waiting to get their cut. In the world of stocks and bonds, this tax is called capital gains tax. There are two kinds, short-term, less than 1 year and equal to your income tax rate, and long-term, anything over 366 days and 15%. Don't worry, this tax only applies to the money you made, not the money you originally invested. Mutual funds tend to trigger larger short-term (aka more expensive) capital gains taxes because they are trading in and out of positions within a calendar year. ETFs have much lower turnover, meaning the investments in the basket change much less frequently. Simply said, fewer changes means lower taxes.
Management Type: Generally, when we hear about ways to manage our investment portfolio, we hear the active vs. passive argument. Active, pretty self-explanatory, but basically investment managers try to outperform the market by trading in and out of various positions. Some argue that doing so allows them to capitalize on market fluctuations, but it's historically extremely difficult to time the market and active managers rarely consistently outperform. The research actually shows that, over a 15-year period, 90% of actively managed funds did worse than the index they were trying to beat. Most mutual funds are actively managed (hence the big team of people and the high capital gains taxes). ETFs, on the other hand are passively managed, meaning they basically follow a buy and hold strategy. If you purchase an ETF that tracks the S&P 500, for example, there is little buying and selling that happens unless one of the companies drops out of the index and is replaced by another one.
All in all, both types of investments have made is easier and cheaper for average Joes and Jills to get access to the stock and bond markets. Sometimes, a mutual fund might make sense (think a target date fund), but generally speaking ETFs are cheaper, better performing assets. Knowing which one is right for you depends on your time horizon and personal investment goals.