With so many products available to investors today, how do you figure out which one is appropriate for you? The thought might seem overwhelming but when broken down, it can be easy to identify what investments work best for you and your financial goals.
Looking at two of the most popular investment vehicles - exchange-traded funds (ETFs) and mutual funds - it can be difficult to distinguish between the unique benefits each offers you as an investor. Each investment vehicle gives you the ability to diversify your portfolio by purchasing shares of a collection of assets, but beyond that the characteristics of the funds begin to differ. Comparing the two side-by-side, you can begin to determine which makes the most sense for your current financial situation and long-term investment goals. (For more, see: When Is the Right Time to Change from Mutual Funds to ETFs.)
When it comes to management strategies, you can choose from two options: active or passive. When selecting from ETFs and mutual funds, you have to consider what management style you desire for your investments.
ETFs are predominantly passive, while mutual funds are often actively-managed products. ETFs typically follow an index fund model, meaning they are designed to reflect a specific market index’s performance. On the other hand, an active management style involves a “hands-on” approach with mutual fund managers actively considering, selecting and selling stocks, bonds and other assets in an effort to outperform the market.
When will you need your money? Depending on your financial needs, the ease of buying and selling an asset can be one of the most important investment factors to consider.
ETFs will usually have the most liquidity. Just like a traditional stock, you can buy and sell ETF shares through a brokerage account and ETFs even allow investors the convenience of trading intraday.
Investing in a mutual fund is fairly easy as well. To buy into a mutual fund, you can either go through a brokerage firm or invest directly through the mutual fund company. However, while ETFs let you trade at your leisure during market hours, mutual funds can only be sold after the closing bell when a fund’s net asset value (NAV) has been calculated for the day.
Cost is probably one of the most important factors to consider in determining whether or not an investment is suited for you. Between ETFs and mutual funds, ETFs rank as the most affordable investment vehicle because of the low expense ratio the product offers - as low as 0.05% annually - as well as a lack of broker fees. (For more, see: Pay Attention to Your Fund’s Expense Ratio.)
Due to their active management style, mutual funds can have significantly higher expenses. When investing in a mutual fund, part of your profit goes toward an expense ratio that includes both a management and administrative fee, which help pay for the behind-the-scenes operations of a fund. Depending on the size and structure of the mutual fund, the expense ratio can be upwards of 20% though most will not be this high.
When it comes to investment earnings, it’s about what you earn after taxes that counts. Mutual funds can suffer from a substantially high tax burden, depending on a number of factors that are out of your control. Since mutual funds are actively managed, fund managers are regularly buying and selling assets in an effort to rebalance the fund. This becomes an issue for investors, because income generated from mutual fund returns is taxed based on how long the fund held the assets it’s selling.
If the assets were held by the fund for more than a year, the income is taxed as capital gains, which can be a significantly lower tax rate than your ordinary income tax rate. Income from an asset that was held for less than a year is taxed at your regular income tax rate and this is typically the case for mutual funds, due to higher asset turnover.
Because ETFs are modeled after an index, there is less asset turnover, minimizing taxable instances. Additionally, since ETFs are traded like stocks on an exchange there’s no taxable transaction, like the one that is incurred when buying and selling a mutual fund.
Which investment vehicle makes the most sense for your needs? We’ve established that mutual funds are accessible and give you exposure to different types of assets. However, management fees can reduce your profits by as much as 2% and in the long term, 90% of mutual funds do not outperform the S&P 500 Index.
For most retail investors, ETFs will likely be the most attractive option due to low fees, liquidity and tax efficiency. Currently, there are more than 1,900 ETFs available, allowing you to find a fund aligned with your goals, your willingness to take risks and the industries or markets you would like to gain exposure to.
Knowing what product best aligns with your goals, you can now confidently work with an investment professional to put together your long-term portfolio management and growth strategy. (For related reading, see: Mutual Fund or ETF: Which Is Right for You?)