Mutual Funds vs. Exchange-Traded Funds
Now that we have finished discussing diversification, we will dive into the most popular, and arguably the easiest ways, to diversify. That is right. This month we are comparing and contrasting Mutual Funds and Exchange-Traded Funds. (If you have not read the past few blog postings, we highly suggest that you do. We covered diversification strategies for equities, bonds, and miscellaneous investments.)
To begin, let us discuss the similarities between mutual funds and exchange-traded funds. First, both products can be considered a bundle of underlying investments. Instead of buying just Apple stock, you can buy a technology fund that will own Apple along with potentially hundreds of other tech companies. Instead of buying a bond directly from one specific company, you may consider spreading out the risk by purchasing a fund compiled of various, highly rated company bonds
Both investments are typically offered by large financial analytical companies. These firms higher the best analysts they can find and allow them to create these bundles of goods for the average investor. Therefore, there is no underlying allocation decision needed by the investor. Investors are not responsible for managing the fund themselves, so they simply need to decide fi they want to buy or sell the fund.
Lastly, due to the cost of the financial analysts, each of these products charge a fee. The internal expenses fees may vary from fund to fund, but that is how these companies make money. They charge investors a fee for holding the fund, so that they can afford to pay the analysts and generate profits.
Next, we will be discussing the differences between mutual funds and exchange-traded funds. To start, let us focus on the underlying management of the funds. As mentioned above, we stated all these funds are typically allocated based on an analyst’s research. However, mutual funds tend to be more actively managed than exchange-traded funds. This means that a mutual fund company is normally buying and selling more often within the underlying investments. They do this with the goal of outperforming their benchmark or outperforming the market via buying winners and selling losers. Exchange-traded funds are more along the lines of buy-and-hold strategies when it comes to the underlying investments.
The differences in the management approach leads us to our next contract. Because mutual funds spend more time buying and selling, they normally charge a higher fee for their active management. Since exchange-traded funds do not analyze their holdings as much and they try to align with a benchmark, these companies tend to have a fewer overall analyst and a lower level of expenses. Because of this, exchange-traded funds tend to charge a lower fee for their products.
Next, we will discuss the differences in taxation. While both products will cause investors to realize gains or losses when the fund is sold, mutual funds may have additional tax factors. Like we stated above, mutual funds often buy and sell underlying investments. When one of the underlying holdings is sold, the investor technically realizes the gain or loss in that specific holding. However, these tax repercussions are usually released once per year via a capital gain distribution. This is not usually an issue with an exchange-traded fund since the underlying positions are not frequently traded.
Lastly, each option has their advantage in terms of flexibility. Mutual funds win in terms of quantities since they usually allow investors to buy fractional shares. Exchange-traded funds may be harder to purchase in smaller accounts since they normally require full shares to be purchased. However, exchange-traded funds have the advantage when it comes to timing. Mutual funds only trade the close of the market at 4:00pm EST. Exchange-traded funds allow investors to buy and sell at any point throughout the day.
If you have any questions about taxes, your individual investment portfolio, our 401(k) recommendation service, or anything else in general, please give our office a call at (586) 226-2100. Please feel free to forward this commentary to a friend, family member, or co-worker. If you have had any changes to your income, job, family, health insurance, risk tolerance, or your overall financial situation, please give us a call so we can discuss it.
We hope you learned something today. If you have any feedback or suggestions, we would love to hear them!
Zachary A. Bachner, CFP®
Robert L. Wink
Kenneth R. Wink
James D. Wink
Summit Financial Consulting