ETFs vs. MUTUAL FUNDS: WHICH IS BEST FOR YOU?

Published on November 29, 2015 by

ETFs vs. MUTUAL FUNDS: WHICH IS BEST FOR YOU?

 

By choosing correctly between these two popular investment choices, you can add thousands and thousands of extra dollars to your investment portfolio. You can do this not only by saving on excessive fees, but also by being able to quickly move out of harm’s way in case of catastrophic market events.

But how do you choose correctly? How do you choose what’s best for you?

Why not let us help.

Let’s start with mutual funds.

Basically, a mutual fund is a basket of many different shares of individual bonds, stocks or other securities which has been selectively put together by either a fund management team or, in some cases, an individual fund manager. The fund’s goal is to diversify the investor’s money across a broad spectrum of securities invested in a specific area such as growth, emerging markets, technology, etc.

Simply put, the price of a mutual fund is based on the total value of the individual investments it holds divided by the number of shares available. During the course of the trading day, the fund’s value won’t change because it is valued only at the end of the trading day, not at the start.

After the markets have closed, the ending value of the securities in the fund is recalculated and a new value established for the fund. That value, divided by the number of shares available, becomes the new share price and remains that way until the close of business on the next trading day. So, using a simple example, if you have a fund worth $1,000,000 when the market closes and there are 100,000 shares outstanding, each share would be worth $10.

Naturally, there are expenses associated with these funds. Mutual fund expenses can typically range between 1% per year to 2% per year. If you’re paying a sales load (commission) as well, the expenses could reach 3.5% annually or maybe more. These expenses include operational fees (such as advertising), redemption fees (designed to prevent excessive turnover within the fund) and commissions.

Sometimes you pay your commissions when you buy the fund (front-ended) and sometimes when you sell (back-ended). For savvy investors, a popular choice is no-load (no commission) mutual funds.

The reason is simple: over many years of investing, excessive commissions can cost an investor thousands of dollars in fees that otherwise could have gone into the investor’s pocket!

And please keep in mind that, in most instances, your monthly statement does not reveal these expenses! Adding insult to injury is the fact that 96% of these funds don’t do as well as index ETFs which are invested in the same sectors.

Isn’t it time to start putting all of this money back in your pocket?

Exchange Traded Funds can help you do that.

Exchange Traded Funds (ETFs), like mutual funds, are a basket of investments. They allow the investor to diversify across a broader range of securities targeted to his/her goal (growth, income, technology, etc.).

However, unlike mutual funds, ETFs are traded throughout market hours and are always liquid. If an emergency arises and an investor decides to sell immediately, it is possible to do so. Not so with mutual funds. But, mutual funds do settle one day after the trade date whereas ETFs take three days to settle (have your money ready to reinvest). This means that the ETF investor may have to wait an extra couple of days to get back into the market with a new trade (although many brokers will go ahead and release the settling funds if the investor so requests and the account meets certain requirements).

Also, with ETFs, an investor can place a limit or stop loss order to create a purchase or sale of his shares at a specific price in order to capture a gain or protect against excessive loss; this cannot be done with a mutual fund.

What about taxes?

Here, we have to say, advantage ETFs.

Let’s keep it simple and stick with the basics.

The manager of a mutual fund can sell the fund’s securities at any time in order to cover share redemptions by other investors or to rebalance the fund (readjust the fund’s holdings to reflect changing market conditions). When that happens, a taxable event occurs.

So, even if a mutual fund was losing money, if the manager created a gain by selling any of his liquidated shares at a profit, the fund’s shareholders will owe the tax on those gains. This is why investors who are not in a tax-deferred account of some kind may end up owing taxes even though their fund has gone down in value for the previous year.

ETFs, on the other hand, put the investor in charge of taxes. Since ETFs don’t have to sell their underlying stocks to meet redemptions, etc. (as they are traded on an exchange like a stock), any capital gains or losses are determined by when the investor chooses to sell his/her shares.

It’s also worth mentioning that most ETFs don’t require a minimum initial investment, unlike most mutual funds. This makes them ideal for the smaller investor who is planning on building an account slowly and consistently.

All in all, it seems to us that for almost any investor ETFs are a better overall choice than mutual funds. We hope you’ll agree with our thinking.

Hope you enjoyed this brief article. If you have questions, please let us know.

J Michael

www.retirementincometimer.com

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