What Should I Invest In?

Are ETFs or Mutual Funds Better For Me?

By Jason Shuster

           One of the most common questions I field is at its most simple form: “what should I invest in?” As an Advisor, my response is usually, “That depends on several crucial factors…” followed by a slew of questions to determine overall goals, time horizon, and risk appetite and capacity. In many cases after all inputs are accounted for and the best option for true diversification appears to be a portfolio of funds, the next question often surfaces: Should we invest in “Exchange Traded Funds (ETFs) or Mutual Funds?”

In order to help answer this question, I'll outline several similarities, differences, and advantages of each.

How Are ETFS and Mutual Funds Similar?

Exchange Traded Funds (often called ETFs) and Mutual Funds are similar in the fact that they are pools of investments that allow the common investor to achieve a greater degree of diversification. They both typically specialize in a particular strategy or index, and both are especially helpful for investors that want to invest in a broad range of investments but don’t have enough capital to achieve it on their own cost effectively. They are also very similar in terms of liquidity. Both types of funds are considered very liquid, with most funds/managers able to return funds to investors in a short amount of time. Both types of funds also carry risk, primarily in the form of management and strategy. Despite these similarities, they are very different from each other.

How Are They Different?

Most investors are familiar with Mutual Funds since they have been a large part of investing for the past 75 years. But what is this lesser-known Exchange Traded Fund? The short answer is, it’s like a Mutual Fund, but it has a trade value, so it can be bought from and sold to other investors, rather than the fund itself being the sole party receiving cash in exchange for shares and redeeming shares from investors and returning their cash value. Mutual Fund shares must be bought from the fund itself, and sold back to the fund upon liquidation. They are bought and sold at the Net Asset Value (NAV) on a once-daily basis, and are only evaluated as such. ETFs also have a net asset value, but often trade at a different price--albeit small in most cases. However, this difference alone is not enough to sway most investors, especially those who care more about the cold hard numbers. The real differences are cost and style of management.

The ETF Advantage

Mutual funds have varied in the way that they charge customers over the years, and today there is a wide variety of overall costs to customers. While there are funds that offer “no load” such as low cost index funds, Morningstar Research conducted a study that concluded that even the average index Mutual Fund had internal costs of around 0.74% of NAV. Many specialized strategies have internal management and distribution costs around 1% to 2.5% of the NAV on an annual basis.

For example, if you invest $10,000 in an actively managed (but not aggressive) Mutual Fund with internal expenses of 2% that generates an annualized gross return of 8%, then the net return an investor would experience would be 6%. Over a five year period, this $10,000 initial investment would then grow to $17,908. 

On the other hand we have the ETF, which according to the same Morningstar research, typically sees an average internal cost of about 0.44%. Even combined with the advice of a Financial Advisor or Planner, ETF investors seeking the same type of portfolio and diversified holdings in our previous scenario could experience an annual total cost of investing around 1.4% of NAV. After 5 years of holding the shares, an investor in this scenario would see a net return of around 6.6%, resulting in the $10,000 investment growing to $18,596 (not counting for taxes). In a vacuum, the ETF wins on the category of low-cost investment.

Another area of differentiation comes in the area of taxation. ETFs tend to be passively managed as opposed to most Mutual Funds which tend to be actively managed. Passive management means less trading, which means less opportunities for capital gains taxes. The actively managed Mutual Fund, which tends to trade more often, may experience more capital gains taxes. In short, ETFs are usually more tax efficient than Mutual Funds.

The Mutual Fund Advantage

Mutual funds still have some advantages. For one, they are inherently more liquid than ETFs based on the fact that shares can be redeemed in most cases at any time. To date, liquidity for ETFs has not been an issue in most cases, but the nature of a traded security is that someday, it could be.

The main advantage to Mutual Funds is that traditionally more active management can take place inside the fund with more diversification and a more comprehensive investment strategy encompassed within fewer funds. This allows for much broader investment strategies into more underlying securities. In theory, this could result in additional returns to investors beyond the overall market in a single fund, which still makes the Mutual Fund very attractive.

 Or, on the opposite spectrum, a Mutual Fund focused on a very narrow investment strategy can nimbly buy and sell holdings based on conviction from the Mutual Fund manager. Of course, this can lead to higher tax consequences in some cases, but it may not be relevant if held with a tax advantaged account such as an IRA or Roth IRA.

In Conclusion

Mutual Funds and ETFs are both great investment vehicles for investors, regardless of experience. Since growth potential is not something that most investors or even fund managers can predict, when making decisions about investing, it’s best to make them based on the things that you know you can control, or that you know are certain.

If you are trying to decide how and what to invest in, work with a Financial Planner or Financial Advisor. There are thousands of ETFs and Mutual Funds out there, and a knowledgeable professional can help you navigate the landscape, assess your risk tolerance, and help you develop a solid investment strategy. Most importantly, an Advisor will help you tremendously by holding you accountable to that strategy, which gives it a much better chance of being successful. Recent Vanguard research shows that an Advisor not only adds peace of mind, but also may add about 3 percentage points of value in net portfolio returns over time.

Once you have a risk assessment, and an investment strategy picked, look at the factors listed here when considering whether to go with Mutual Funds or ETFs. What other factors do you consider to be important?

Sources

1. “How to Choose an Exchange-Traded Fund (ETF)” The Wall Street Journal
2. guides.wsj.com/personal-finance/investing/how-to-choose-an-exchange-traded-fund-etf/ Accessed 9/27/2017
3. Pareto, Cathy “Mutual Fund Vs ETF: Which is Right For You?”, Investopedia www.investopedia.com/articles/exchangetradedfunds/08/etf-mutual-fund-difference.asp Accessed 9/27 2017
4. www.Morningstar.com 
5. The Added Value of a Financial Advisor, Investor’s Note

The article and opinions in this publication are for general information only and are not intended to provide specific advice or recommendations for any individual. I suggest that you consult your accountant, tax, or legal advisor with regard to your individual situation.