Mutual Funds vs ETFs

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ETFs vs Mutual Funds

Mutual funds and ETFs both involve pooling money that becomes part of a big fund invested in a mix of different assets. Depending upon the ETF or mutual fund, it is possible to gain exposure to a broad mix of different assets with just a single fund purchase. This makes it easier to diversify and potentially reduce risk compared with purchasing stock shares in a single company.

While ETFs and mutual funds have a lot in common, there are important differences between them that you should understand when you decide which investment is right for you.

ETFs vs Mutual funds: Which are better?

When you are choosing between mutual funds and ETFs, here are a few key pros and cons that can help:

Mutual Funds vs ETFs - Fees and Expenses

In almost every case, ETFs cost investors less than mutual funds. All else being equal, the structural differences between the two products do allow ETFs a noticeable cost advantage over mutual funds.
Mutual funds charge a blend of transparent and not-so-transparent costs that add up. It’s simply the way mutual funds are structured.

Mutual funds charge their shareholders for everything that goes on inside the fund, such as transaction fees, distribution charges, and transfer-agent costs. In addition, they pass along their capital gains tax bill on an annual basis. These costs decrease the shareholder’s return on his investment. On top of that, many mutual funds charge a sales load for allowing you the pleasure of investing with them. These loads are either pure profit for the mutual fund or a yearly financial incentive payment for your broker.

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The Differences Between ETFs and Mutual Funds

ETFs are traded like stocks. They’re priced based on what investors think the market value is and you can buy and sell shares throughout the day. Mutual funds, however, can only be purchased or sold at the end of the trading day after the market closes and their price is based on Net Asset Value (NAV) — the value of fund assets minus liabilities divided by the number of shares.

When you decide to sell your mutual fund shares, the same process occurs in reverse. But buyer beware, some mutual funds assess a penalty for selling early, typically sooner than 90 days after you bought in. This penalty could be a substantial sum – sometimes 1% to 5% of the shares’ value. Investors in ETFs don’t face that prospect. As the name suggests, Exchange Traded Funds trade on exchanges, just as common stocks do, and the other side of the trade is some other individual investor like you, not the mutual fund company. You can buy and sell at any point during a trading session at whatever the price it is at the moment based on market conditions, not just at the end of the day, and there’s no minimum holding period. This is especially relevant in the case of ETFs tracking international assets, where the price of the asset hasn’t yet updated to reflect new information, but the US market’s valuation of it has. ETFs can reflect the new market reality faster than mutual funds can. The daily value of the mutual funds are calculated at the end of the day and posted approximately 2 hours after the stock market closes.

Another key difference is that most ETFs are index-tracking, meaning that they try to match the returns and price movements of an index, such as the S&P 500. This is accomplished by assembling a portfolio that matches the index constituents as closely as possible. Mutual funds can track indexes too, but most are actively managed; in that case, the people who run them pick holdings to try to beat the index that they judge their performance against. That can get pricey. Actively managed funds must spend money on analysts, economic and industry research, company visits, and so on. That typically makes mutual funds more expensive to run — and for investors to own — than ETFs.

ETFs often require lower minimum investments

Although there are some options for mutual funds that don’t require you to invest a lot of money at once, many mutual funds have high initial investment requirements. This makes it a challenge to get started investing in a mutual fund if you don’t have a lot of money saved. ETFs allow you to buy as little as a single share, which means that you don’t need a fortune to start investing in the market.

Mutual Funds Expense Ratios

There is a section called “Annual Fund Operating Expenses” in a mutual fund’s prospectus, after the load disclosure. This is better known as the mutual fund’s expense ratio. It is the percentage of assets paid to run the mutual fund. Well, most of them. Many costs are included in the expense ratio, but typically only three are broken out: the management fee, the 12b-1 distribution fee, and other expenses. And, it’s not that easy to find out what fees are contained in the “other expenses” category.

In addition to paying the portfolio manager’s salary, the management fee covers the cost of the investment manager’s staff, research, technical equipment, computers, and travel expenses to send analysts to meet corporate management. While fees vary, the average equity mutual fund management fee is about 1.40%, according to Investopedia.

Mutual Fund 12b-1 Fees

Most mutual funds, including many no-load mutual funds and index funds, charge a special marketing fee called a 12b-1 fee.
The 12b-1 fee is broken out in the mutual fund’s prospectus as part of the expense ratio. It can run as high as 0.25 percent in a front-end load fund and as high as 1 percent in a back-end load fund according to Morningstar. Many investor-right advocates consider these expenses to be a disguised broker’s commission.

One thing can be said for the front-end and back-end loads: they’re upfront about what the fee will be, and it’s a one-time charge. Essentially, you go to a broker, he or she helps you to buy a mutual fund, and you pay for the service.

This is not the case with the 12b-1 fee. While it is intended to pay for promotion and advertising, only 2 percent of the fees are used for that. The rest is paid to brokers for ongoing account servicing. Essentially, it’s paid to the broker who sold you the mutual fund on an annual basis, for as long as you own the fund, even if you never see him again.

ETF Costs

In contrast to mutual funds, ETFs do not charge a sales load. ETFs are traded directly on an exchange and are subject to brokerage commissions, which can vary depending on the firm, but generally are no higher than $5.
In one of our investment models, Research Financial Strategies offers an aggressive growth strategy with no trading fees through Schwab.

ETFs expense ratios generally are lower than mutual funds, particularly when compared to actively managed mutual funds that invest a good deal in research.  And ETFs do not have 12b-1 fees according to Morningstar.

ETFs often have lower fees and expenses

ETF expense ratios are typically lower than mutual fund fees. In 2016, the average expense ratio of index ETFs was just 0.21% compared with a 0.59% average expense ratio of actively managed mutual funds and a 0.27% expense ratio for index equity mutual funds, according to Investment Company Institute. Many mutual funds include a variety of fees in their expense ratio, including fees to cover marketing and distribution costs.

ETFs provide more transparency

ETFs typically disclose holdings daily. Actively managed mutual funds typically disclose their holdings on a quarterly or semi-annual basis.

Transferability of ETFs

Whenever a managed portfolio is switched to a different investment firm, complications can arise with mutual funds. Sometimes the fund positions must be sold before a transfer can take place. That can be a major headache for investors, being forced to make unwanted or untimely trades. Liquidating a portfolio’s mutual funds may increase risk, increase commissions and fees, and incur early capital gains taxes. With an ETF, the transfer is clean and simple when switching investment firms. ETFs are considered a portable investment, which is a nice advantage over mutual funds.

The Case Against Mutual Funds

Mutual funds are more expensive, on average, than ETFs. As mentioned, the average expense ratio for ETFs is 0.21%. Mutual funds, on the other hand, average 0.59%, though many are above 1% due to things like 12b-1 fees, which essentially compensate advisors for selling a given fund.

Mutual funds are also generally actively managed. Active management is not a bad thing, per se, though it can bring added cost and tax situations for investors they may not be expecting or know how to manage. Plus, there is the risk of underperforming the overall market.

Lastly, many mutual funds have minimums to open an account. In many instances that may be $1,000 or $2,500, so you’re not able to invest in the given fund unless you have that amount of money to invest. For many investors just starting out, this can hold them back when they otherwise could be investing in an ETF.

So, Who Wins the Battle of Mutual Funds vs ETFs?

Are ETFs better than mutual funds? If you are faced with an ETF vs. mutual fund dilemma, one must consider the disadvantages of mutual funds and the advantages ETFs bring to the table. And as with any investment, a company stock, mutual fund, an ETF, index or otherwise, please make sure you thoroughly research any exchange traded fund or any financial asset before making any trades (long or short). Conduct your due diligence, watch how funds react to different market conditions, take a look under the hood and see what is in the funds. And if you have any questions or concerns, the financial advisors at Research Financial Strategies are here to help you.  It is very important to understand the investment vehicle before you trade it. But once you have a full understanding on  ETFs, you can consider adding them to your portfolio.

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