The Showdown…Mutual Funds vs. ETFs
Investing in the stock market isn’t only about individual companies, like Apple or Amazon.com. There are mechanisms that allow for investing in multiple companies all at the same time. Mutual funds and exchange traded funds (ETF) were created to do just that, plus offer a reduced risk factor. Mutual funds were established back in the 1920s, while the new school ETFs were created more recently in 1993.
A mutual fund is an investment tool made up of stocks, bonds, money market, or other assets. Investors contribute their funds into a pool, which is controlled by a money manager, in order to produce profits and income disbursements. Every fund has a prospectus which details the structure and purpose of the fund.
Since mutual funds invest in a range of investments to create a diversified portfolio, it allows for the everyday investor or limited capital investor to participate. Professional money managers lead the directions of investments for those investors who may not have the knowledge to invest their own money. Each individual shareholder owns a percentage of the fund, in which their stake contributes to their gains or losses.
The performance is typically tracked by the change in the total market capitalization of the fund. This is determined by combining the investments within the portfolio. A common term relating to mutual funds is the net asset value (NAV). A fund’s NAV is calculated by dividing the total value of the investments in the portfolio by the total number of shares outstanding.
Just as many other investment vehicles, there is an entry fee for buying into a mutual fund. The fee is composed of a combination of a management, advisory, and/or administrative fee. A fund will display their front end or back-end fees before investors enter the fund, known as the load. Any fund that carries a front-end load requires fees be assessed for the initial entry buy. The opposite goes for back-end loads, in which investors are charged a fee when they sell shares of the fund. There are mutual funds offered directly from investment companies that offer no-load mutual funds, which do not charge a fee on either end.
Prices are only adjusted at the day’s end, so taking advantage of short-term movements are more difficult. Due to management and research fees being passed on to the fund’s investors, returns are reduced. Also, at year’s end mutual funds issue capital gains regardless of performance, which increases taxable income.
Exchange-Traded Fund (ETF)
An exchange traded fund (ETF), is similar to an index fund, in that it tracks a pool of bonds, commodities, stocks, or all. What separates it from a mutual fund is that ETFs trade on the stock market like individual stocks do. Being so, they have daily jumps in prices like stocks do. However, being on the exchange they offer an option to invest in similar securities at a lower fee than mutual funds. Investors can buy as little as one share, there is no minimum deposit requirement like mutual funds require.
Because it operates similar to an index fund, shareholders do not outright own any of the individual investments in the fund. This allows for investors to easily buy and sell the fund to potentially profit from gains just as stocks perform. Shareholders do not receive disbursements in the way mutual funds do, but they are entitled to their proportion of the earned interest or dividends. Capital gains from sales inside the fund are not passed through to shareholders as they usually are with mutual funds. Many 401(K) or employee sponsored plans do not offer ETFs.
Unlike money managers who establish mutual funds, ETFs go through a different process called creation and redemption. The process begins with a group of large specialized investors, known as authorized participants (APs). Large financial institutions with high levels of buying power are authorized participants. The creation and redemption of ETFs are limited solely to APs. The process starts with an AP collecting the assets to include in the portfolio. Then this is handed over to the fund in conversion for the new shares. On the redemption end, APs will send back shares to the fund in exchange for the portfolio of assets. Because every day the portfolio’s holdings are provided to the public, any adjustments can be viewed by every investor.
One of the most commonly traded ETFs, called the Spider (SPDR) tracks the S&P 500 Index large cap stocks. The Diamonds (DIA) ETF mirrors the Dow Jones Industrial Average. There are also sector ETFs such as: XLP – Consumer Staples, XLF – Financials, XLK – Technology, and many more.
Sum It Up
Mutual funds and ETFs are known as highly recommended investment tools for individuals with a limited amount of investable capital. Having a professional money manager invest a person’s personal income is a traditional method for many individuals. However, the expenses that come with mutual funds can be expensive and add up over time. Not every fund performs the same, nor holds the same level of integrity.
A common excuse for people not investing their own money is their lack of time or experience. ETFs are a great source for those individuals to start with. The low commission fees and similarities to the overall market leading index funds allow for low risk and sustainable performance. Neither investment strategy is a bad choice for potential gains. Make sure to weigh the advantages and disadvantages for your personal investing goals.