How should you go about investing?
Investing in individual stocks gives you the most control, but for newcomers and even intermediate investors, this idea poses a challenge. Each stock needs to be well-researched and chosen for specific characteristics.
Many investors look to investment vehicles like exchange-traded funds (ETFs) and mutual funds as a way to solve the problem. Both types of funds provide access to a highly diversified portfolio with a single investment, taking much of the research and legwork out of the process. But ETFs have a distinct advantage over mutual funds.
What Are Mutual Funds?
Mutual funds are a managed portfolio investment that pools investment dollars from a large group of investors and invests according to the strategy outlined in the fund’s prospectus. When gains or dividends are enjoyed, each participant in the fund shares in the returns based on their share ownership.
In general, mutual funds are actively managed, following investment strategies designed to produce significant growth in the search of alpha — in other words, looking to beat average market returns.
In many cases, these funds will have a strategy of using high-risk derivative investments to multiply the results of a benchmark index. For example, the fund’s strategy may be to use derivatives to return twice the performance of the Dow Jones Industrial Average or S&P 500 index.
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What Are Exchange-Traded Funds?
Exchange-traded funds, or ETFs, are also bucket investments that pool money from a large group of individual investors, and then invest in various assets based on the strategy outlined in the prospectus. As the fund generates returns, they are shared by all investors based on the number of shares they hold.
As the name of these funds suggests, ETF shares are traded on stock market exchanges like the New York Stock Exchange or Nasdaq, which differs from mutual funds.
Another major difference between these two types of funds is that the vast majority of ETFs are passively managed, meaning the portfolios essentially run themselves without a fund manager actively buying and selling, which greatly reduces cost. In fact, according to Forbes, only about 2% of ETFs are actively managed.
One of the most common forms of these funds is known as the index ETF, often referred to as index funds. These investment portfolios are composed of all the stocks listed on a major market index in an attempt to replicate the returns in a sector or the whole market.
Very little trading actually occurs inside index funds because their positions only change when stocks are added or removed from the underlying index for the fund — unlike mutual funds, which could make several changes to their holdings in a single trading day.
Why You Should Invest in ETFs Over Mutual Funds
Although the potential to generate gains at a rate that doubles or even triples what you see from major market indexes is an exciting idea, there are some major drawbacks to chasing alpha and significant benefits to taking a more measured approach with ETFs.
1. Reduced Risk
Any fund you invest in will clearly lay out its investment objectives and its investment strategy in its prospectus. Paying close attention to the strategies employed by mutual funds, you’ll generally find that there’s significant risk involved, whereas the opposite is generally true for ETFs.
ETF investors are looking for a long-term, relatively stable opportunity to build wealth. These fund shares don’t promise outsize returns. In fact, they often work to mirror the returns the market generates, and those reasonable expectations come with a more reasonable risk profile.
2. Mutual Funds Don’t Always Generate Outsize Gains
When you consider buying mutual fund shares, you may think you’re going to make out like a bandit. Who doesn’t want to beat the market? But beating the market is incredibly difficult, even for mutual fund managers.
According to Vanguard, only about 18% of active mutual fund managers beat their underlying benchmark over a 15-year period. That means in 82% of the cases, investments that simply kept pace with the market would have outperformed their higher-cost, actively traded peers.
The reality of actively traded funds gets worse when you look at the 18% of overachievers in more detail. 97% of the managers that actually did beat the market had at least five years of underperformance in that 15-year period, with more than 60% having seven or more years missing market averages.
What the prospectus may say, what you think your returns will be, and reality are often very different.
3. Transaction Flexibility
ETF shares are easy to access and often just as easy to offload when it’s time to exit your position. That’s because these funds are exchange-traded, available to investors of all stripes to buy and sell on the Nasdaq, NYSE, and other exchanges, both big and small.
Access to mutual funds is very different. Although these funds are available through a few different methods, they aren’t traded on the open exchanges, making it more difficult to buy and sell shares. In order to purchase these funds, you will need to go directly through the fund manager.
Sure, some brokerages and other services offer access to them, but they’ll also generally charge an additional fee for placing your orders.
4. Lower Cost
No matter which way you choose to go, there will be fees involved. After all, someone has to create the fund and manage it, making sure that it follows the plan outlined in the prospectus. That person or team needs to be paid for their work, and their salaries aren’t cheap. Not to mention the cost of making the trades themselves.
These expenses are outlined in a fund’s expense ratio, which shows the overall cost of ownership as a percentage of the investment’s value on an annual basis.
ETFs trade minimally, often holding investments for the long haul, reducing the transaction fees associated with the investment and helping to generate low expense ratios. Another factor that leads to a lower expense ratio is the reduced management fees as a result of not having to actively trade day to day.
Mutual funds have teams of traders and analysts that need to be paid, while passively managed ETFs don’t. As a result, ETFs naturally become the low-cost alternative to actively managed funds.
5. Tax Advantages
Returns from investing are taxed in different ways depending on how they’re generated. Returns generated from an investment held for less than one year are taxed like ordinary income.
Profits generated from investments held for more than one year are charged capital gains taxes, which can be significantly lower than your income tax rate, depending on your tax bracket and the amount of capital gains generated.
Because mutual funds are actively traded, their returns tend to fall under the less-than-one-year category. Returns from investments held in these funds are generally taxed at your standard income tax rate, which can be expensive for high-income earners.
ETFs are tax-efficient.
The majority of ETFs hold stocks in their portfolios for long periods of time — often years or even decades. As a result, the majority of returns generated through these investments will be taxed at the capital gains rate, rather than the income tax rate, offering superior tax efficiency.
6. Full Investment Exposure
Mutual funds generally hold a percentage of their net asset value, or NAV, in cash in order to maintain enough funding to pay back any investors wishing to cash out. As a result, that portion of the fund’s assets isn’t getting any exposure to the potential gains the market has to provide.
Because ETFs are exchange-traded, shares are purchased and sold through a broker-dealer just like a stock. That means they are able to invest their full NAV, providing 100% exposure to the market for their investors.
7. No Minimum Investment Requirement
There’s no minimum investment required to purchase an ETF other than the price of a share itself, which generally ranges from tens of dollars to a few hundred dollars. As a result of the low cost associated with investing in these funds, they are far more popular than their actively traded counterparts.
When investing in mutual funds, you’ll typically be asked to make a minimum investment ranging from $500 to $5,000, with the average being around $2,500. That’s a significant chunk of change for a new investor just starting to build a portfolio.
Liquidity — how easy it is to turn your investment into cash when it’s time to sell shares — is a major factor that you should consider regardless of what you’re investing in.
ETFs are highly liquid investment vehicles that enjoy incredibly high demand. A quick look at the most popular ETFs by trading volume at the ETF Database shows some of these funds trade hands nearly 100 million times per day.
Mutual funds are also liquid, and you should be able to sell your shares at any time. That is, as long as everyone else isn’t cashing in on the fund at the same time.
Keep in mind that these funds hold a portion of their assets in cash to pay investors that want out. If a flood of investors decide to exit all at once and the fund doesn’t have enough cash on hand, you may find yourself waiting to access your money.
Throughout history, humans have been in pursuit of more. The idea that you can have more than you do now is what drives you to get an education, work hard in your career, and make many of the investments you do in yourself and in the market.
Naturally, when you see a mutual fund that offers you the opportunity to generate a stronger return on your investment than an ETF, it seems like a no-brainer. Why wouldn’t you want the bigger return?
However, the promise of larger returns in the stock market, or in any area of investing, is generally a double-edged sword, where outsize profit potential is paired with outsize risk, and often cost.
Although there are some actively managed funds that have outpaced the market, these are rarities. Promises of outsize returns through these funds are broken more often than not, but the high cost associated with investing in them is always as described. All in all, passively managed ETFs are a better fit for most investors.