ETFs vs Mutual Funds

ETFs vs Mutual Funds

Choosing between mutual funds and Exchange Traded Funds has been quite a dilemma for those who are working and those who are already retired. Well, it’s more likely that they believe both are good and beneficial. That’s where the predicament gets serious. So, we have compiled here the possible benefits of both, to help you decide better. This is going to be ETFs vs. Mutual Funds, so buckle up.

Know which is which. Learn more about ETFs vs. Mutual Funds before you invest in them!
Know which is which. Learn more about ETFs vs. Mutual Funds before you invest in them!

However, before we dive in there, we’ll first give you some pointers.

Learn more about investment types. Read Investing 101: Different Types of Investments

How to Choose? ETFs vs Mutual Funds

Here are some of the things you have to consider before choosing:

Your Trading Strategy

This is arguably the most important factor to consider if you weighing between ETFs and mutual funds.

In other words, if you’re more comfortable with a passive trading strategy, there are some options coming from both ETFs and mutual funds. When you use a passive trading strategy, it means you like to invest in a given product and then you let it grow over time—with minimal monitoring.

ETFs, on one hand, are basically passive investments. This is because most of them track a given index, with the aim to match its returns. A huge number of indexed mutual funds use the same strategy. What does that mean? It simply means that the fund invests in all the stocks in the index in question. This also implies that there’s little trading activity, except when the underlying index adds or removes a security. And that doesn’t happen often.

On the other hand, if you are more of the aggressive type and you have a high risk tolerance, a passive investment might not satisfy you. If you yearn for a more active trading style, then mutual funds may be the one for you. They offer a broader range of options. An active trading style means a professional picks individual security, which is expected to outperform the market.

ETF vs Mutual Funds Infographics

Your Goals

You must remember that your investment strategy and your goals come together. In other words, your passive strategy comes with the goal of generating steady growth over time. Meanwhile, an active strategy can hit more goals because of the various products available. 

For instance, you want to generate steady investment income yearly for your 401(k) distributions or pension payments. You may want to choose dividend-paying mutual funds to maximize your yearly income. You then have to invest only in stocks with impressive histories of generous dividends.

Read further about dividends. See Dividend Stocks: Illusions and Misconceptions

If you want to take advantage of market volatility to gain quick returns, you may want to choose aggressive, high-yield mutual funds. These offer high-risk-high-reward options for any sector or industry.

Many investors believe that if you’re planning for retirement, you should use a passive strategy. This is obviously because of its relative safety compared to active management. However, you investment goals will better dictate the amount you have to invest. Depending on such goals, actively managed products with potentially higher gains can be a great addition. Still, keep in mind that you have to endure higher risks.

Tax Implications

When deciding between ETFs vs. mutual funds, understanding the tax implications becomes imperative.

Taxable investment accounts are held outside of any tax-deferred retirement savings account. If you sport this kind of account, your investment gains will influence your taxes in the year you earn them. This can entail a huge tax-impact difference between ETFs vs. mutual funds.

On one hand, mutual funds should distribute all net gains to shareholders at least once per year. These gains include any dividend or interest income. This automatically increases your taxable income. They can tax those earnings as ordinary income, though they can also tax them as long-term capital gains. It depends on the length of your investment and the fund’s turnover ratio. Well, you get the same result: your tax increases.

Additionally, actively managed funds usually have much higher turnover ratios. This also increases the possibility that they will tax your gains at your highest rate. This is also somehow true for passive funds. Even if these funds have lower turnover, they typically make taxable capital gains distribution due to inefficiencies in the share redemption process.

ETFs, on the other hand, make very few capital gains distribution since you manage them passively. This makes them a more tax-efficient investment.

However, if you work and contribute to an employer-sponsored retirement savings plan, tax implications can be largely different. Even if many retirement savings vehicles don’t allow investments in ETFs, assets held in these accounts accrue earnings. They will not tax such earnings until you withdraw them.

ETFs: Advantages

Now that you know what to consider before choosing, we’ll give you the advantages of investing in either ETFs or mutual funds. Let’s start with ETFs.

ETFs have numerous advantages over conventional open-end funds.

Flexibility

Generally, we trade traditional open-end fund shares once per day after markets close. We do all the trading with the mutual fund company that issues the shares. Consequently, you must wait until the end of the day. This is when they announce the net asset value. Trading once a day is okay for many long-term investors, but sometimes you may want greater flexibility.

Meanwhile, you can choose ETFs if you want to buy and sell during the day while the markets are open. Throughout the day, share prices change based on the changing intraday value of the assets in the fund. You can know in a short time how much you paid to buy shares and how much you got after selling.

This makes portfolio intraday management quick. It also makes it easier to move money between asset classes like bonds, stocks, or commodities. You can get your allocation into the investments in a shorter time, and then you can change that as quickly.

If you want to do such changes to conventional open-end funds, you’ll face some challenges. It can actually take several days. You have the typical 2:00 pm EST cutoff for placing open-end share trades. You do not know what the NAV price will be. It is impossible to know how much you will receive. You also cannot know how much open-end fund you should buy.

Moreover, you can also make timely investment decisions. You can place orders in various ways. Plus, you can engage in short selling to other ETF investors. This means you can borrow securities from your brokerage and sell those securities in the market. The idea is to wait until the borrowed securities’ price to drop. And then you buy them back at a lower price.

Diversification and Risk Management

ETFs make it possible for you to expose yourself to specific sectors, styles, industries, or countries. You can do that without having expertise in such areas.

Nowadays, you can trade ETFs on every major asset class, commodity, and currency. In some situations, you may suffer risk in a sector but you cannot diversify that risk. In that case, you can short an industry-sector ETF, or you can buy an ETF that shorts an industry.

Lower Costs

No matter the structure, you will incur operating expenses in all managed funds. You may have to pay for management fees, custody costs, and other expenses. We also take costs into account when we forecast returns. As a rule, the lower the cost of investing, the higher the expected returns.

You can streamline ETF operation costs compared to open-end funds. You may incur lower costs because client service-related funds are passed on the brokerage.

ETFs also have lower charges with monthly statements, notifications, and transfers. Open-end funds send statements and reports to shareholders regularly. ETFs don’t. Fund sponsors provide that information to authorized participants only. These participants are the direct owners of creation units.

Tax Benefits

ETFs can give you two major tax advantages over mutual funds. Mutual funds have a structure that lets it incur more capital gains taxes than ETFs.

You can only incur capital gains tax on an ETF upon your selling of the ETF. This means that ETFs have lower capital gains, payable only upon the sales of the ETF.

Meanwhile, dividend-related tax situation is less advantageous. ETFs issue two kinds of dividends—the qualified and unqualified. The dividend should fall under your grip for 60 days to be considered qualified. Meanwhile, unqualified dividends are taxed at your income tax rate.

Mutual Funds: Advantages

Now that you have an idea what ETFs are and what they give you, here are some perks you can get from mutual funds. They will help you choose better.

Variety

Although you can find this in ETFs, you can spot more variety in mutual funds. There are wide-ranging varieties you can invest in, and they come available for different types of investment strategies, risk tolerance levels, and asset types.

Overall, the advantage of mutual funds over ETFs is that they offer a plethora of actively and passively managed options. You can fine-tune these options to your specific needs. In other words, you can invest in mutual funds to choose a product that fits your goals and risk tolerance.

You can choose a more stable investment for steady, modest return. Or you can choose an investment that provides regular earnings each year. OR you can select an aggressive product which you can use to beat the market. Mutual funds have virtually every kind of product.

No Leverage Risk

As you may know, there are also actively managed ETFs. If you use borrowed money to swell your fund’s investment’s size, leverage ETFs can magnify your returns. These securities are still tracking a given index. However, if you use debt without the equity to back it up, leveraged ETFs become a different species of investment.

Leveraged and inverse ETFs can be very fickle. Even if they can be very lucrative when the market performs as expected, the combination can still be very risky. What combination? The mixture of leveraged returns and day-to-day market volatility.

In comparison, mutual funds provide all possible combination of security and risk.

For instance, if you root for an investment that’s for long-term capital gains, there’s a mutual fund for that. One that primarily invests in tested growth stocks but aims to gain from up-and-coming businesses for exponential growth.

Moreover, mutual funds have restrictions over the amount of leverage they can use. Mutual funds can borrow funds equal to 33.33 percent of its shareholder equity. On the other hand, most of them ditch the use of leverage.

Quality of Service

You know that mutual funds can be more expensive that ETFs. In fact, ETFs normally have lower expense ratios since they offer minimal shareholder services. Still, mutual funds have fund managers who provide support services. They typically provide free fund transfers, check-writing options, and other services. Needless to say, ETFs do not provide such services.

Investment Options

Mutual funds offer automatic investment plans, which you can’t find in many ETFs. These services can facilitate regular contributions, while you sit in front of your tv relaxing. That means you don’t have to do anything while they do that.

 If you use this option, you can automatically increase your mutual fund investment each month. That’s for a predetermined amount, of course. It’s an easy way to build up your investments without having to monitor them all the time.

Moreover, most mutual funds offer dividend reinvestment plans. By using this plan, you can use any dividend income to buy additional shares. DRIPs can save you from stressful decision making. They automatically convert dividends into investment growth vehicles.

No Commission Fees

Come to think of it, your investment plan includes increased investments as time goes by. As for ETFs, their lower expense ratios are offset by the broker commissions every time you buy or sell shares.

Even if mutual funds sometimes carry fees for new investors, you’ll find investment growth cheap and easy. The availability of auto investment and DRIP options also enables effortless incremental mutual fund investment.

The Final Decision

We’re almost done weighing ETFs vs. Mutual Funds. But before we end this, you still have to learn more about them. Read further about each, and consult with other experts in their respective fields. Lastly, why not choose both? Either way, all you have to remember is your choice depends on your goals and strategy. Remember that you are your best investment.

 

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