Now that we have finished discussing diversification, we will dive into the most popular and arguably the most straightforward ways to diversify. That is right. This month we are comparing and contrasting Mutual Funds and Exchange-Traded Funds (ETF). (If you have not read the past few blog postings, we highly suggest you do. We covered diversification strategies for equities, bonds, and miscellaneous investments.)
Similarities of Mutual Funds and ETFs
First, let us discuss the similarities between mutual 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 and hundreds of other tech companies. Instead of buying a bond directly from one specific company, you may consider spreading the risk by purchasing a fund of various highly rated company bonds.
Large financial analytical companies typically offer both investments. These firms hire 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. However, investors are not responsible for managing the fund themselves, so they need to decide if they want to buy or sell the fund.
Lastly, due to the cost of the financial analysts, each of these products charges a fee. The internal expenses fees may vary from fund to fund, but that is how these companies make money. They charge investors a price for holding the fund so they can afford to pay the analysts and generate profits.
Mutual Funds vs. ETFs: The Differences
Next, we will discuss the differences between mutual 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 usually buys and sells more often within the underlying investments.
They do this to outperform their benchmark or outperform the market via buying winners and selling losers. On the other hand, 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 lead us to our next contract. Because mutual funds spend more time buying and selling, they usually charge a higher fee for their active management.
On the other hand, since exchange-traded funds do not analyze their holdings as much and try to align with a benchmark, these companies tend to have fewer overall analysts and lower 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. As we stated above, mutual funds often buy and sell underlying investments. Therefore, 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 yearly via a capital gain distribution. On the other hand, an exchange-traded fund is not usually an issue since the underlying positions are not frequently traded.
Lastly, each option has its advantage in terms of flexibility. Mutual funds win in quantities since they usually allow investors to buy fractional shares. Exchange-traded funds may be harder to purchase in smaller accounts since they typically require full shares.
However, exchange-traded funds have the advantage when it comes to timing. Mutual funds only trade at the close of the market at 4:00 pm EST. Exchange-traded funds allow investors to buy and sell at any point throughout the day.
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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