As an investor, you’re always looking for the products and investment strategies that could be right for you. As advisors, we’re committed to helping you make educated decisions. In this article, we’re going to look at the similarities and differences between mutual funds and exchange-traded funds (ETFs). Both have their strengths and drawbacks, and it’s important to know the details before you invest.
Note: there are two types of mutual funds: closed-end and open-end. To keep things simple, we’re going to focus on the more common open-end mutual funds in our comparison with ETFs.
First, let’s talk about what makes mutual funds and ETFs similar:
- Both investment structures act as a pooled investment for those that purchase them.
- They’re a way to gain broader exposure and diversification than a singular stock.
- Typically – but not always – these pooled investments will follow a particular strategy such as “large-cap growth” or “small-cap value.”
How they’re traded
While stocks trade throughout the day, open-end mutual funds are only updated once per day when the market closes. ETFs trade closer to stocks, with intraday trading and price quotes.
How they’re taxed
Mutual funds tend to be less tax efficient than ETFs because they pass through capital gain distributions to the investors. For example, imagine you invested in a mutual fund focused on tech. While you may not see it, the investment managers of that mutual fund are constantly buying and selling positions in technology companies. Those profits and losses are distributed to you at the end of the year, creating a potentially higher tax burden than an ETF that doesn’t pass these taxes along to its investors.
ETFs publish their underlying holdings daily while mutual funds typically only publish their underlying holdings quarterly. Therefore, it can be murky to know exactly what you’re invested in when contributing to a mutual fund vs. an ETF.
Mutual funds are known to hold about 5% of their positions in cash to handle redemptions from the fund by shareholders. This means only 95 cents on the dollar is being put to work in a mutual fund. Comparatively, ETFs are typically investing 100 cents of every dollar contributed.
Sales Charges/ Minimums
On average, ETFs are cheaper to purchase than mutual funds. Mutual funds can have sales loads – also known as redemption fees – on the front or back end when you buy them. ETFs don’t have these types of sales loads associated with them. They also tend to have lower administrative costs which help them have lower expense ratios (embedded fees) when compared to mutual funds.
Also of note, mutual funds can have minimum amounts needed to gain investment access. ETFs do not have these minimums, making them more accessible.
Active vs. Passive
If you’re looking for an active investment, this is where mutual funds dominate over ETFs. Fund managers can be much more strategic and active in their investment choices than within the ETF structure. At Denver Private Wealth Management, we make sure to use that to our competitive advantage. Asset classes such as fixed income, international equities and small caps have inefficiencies that are easier to exploit through active management – potentially leading to outsized returns compared to their passive ETF counterparts.
Typically, ETFs are reserved for passive investing where it tracks an index. We have been seeing more active ETFs recently, however on a high level the principle remains that active investing is easier in a mutual fund format than an ETF structure.
While both mutual funds and ETFs have pros and cons, they each have their place in the investment landscape. At DPWM, we encourage you to always be cautious, stay educated, and understand the impact of each investment vehicle.
Denver Private Wealth Management is an independent fee-based financial planning practice with 80+ years of experience in the financial industry. DPWM customizes portfolios based on your financial goals and works closely with you, your tax advisors and estate attorneys to form a comprehensive view of your financial situation. For more information or to set up a free consultation, contact us at firstname.lastname@example.org.
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