Finance professionals love to sound smart. It seems like the ideal situation for the financial world would be for the average person to listen to them and think to themselves, “Man, that guy/gal is brilliant. I only understood ten words of that, but they must know how to make money.” Luckily, the topics usually aren’t as complicated as they sound. As for the topics that are… those are usually a good way to lose money fast.
One topic that has become more relevant in recent years is the difference in Exchange Traded Funds (ETFs) and Mutual Funds. ETFs are a newer product that have gotten a lot of media attention, but most people don’t understand the differences between them and mutual funds. I am going to cover how these investments are very similar, but how ETFs have a couple characteristics that have made them very popular recently. Then we can figure out how you should use these investments in your life.
How are they similar?
Both mutual funds and ETFs hold a group of stocks or bonds. They are classified by what type of investment they hold. Investors use them as a simple way to diversify their portfolios. Each fund has a company and manger(s) that makes sure the fund is in line with the investment goal. Let’s say you want to add small US companies to your portfolio. You could research and pick one or two companies and buy those stocks. However, these companies usually have less information and can be more at risk of failing. Instead, you can buy a small cap fund. This allows you to invest in hundreds of small companies and diversifies your portfolio. Vanguard offers a mutual fund (ticker – NAESX) or ETF (ticker – VB) that hold almost the exact same investments. So which fund do you choose?
How are they different?
Passive Investing – Most ETFs are set to track a benchmark. That means that the manager is only changing the holdings when the benchmark changes. Mutual funds can have active or passive managers. Active managers who buy and sell investments within the funds to try to beat the benchmark that they are compared to. ETFs are usually only set up as passive investments.
Traded – One thing that people love about ETFs is that they are traded during the day. Mutual funds are all priced at the end of the trading day. If you put an order in to buy or sell a mutual fund, you must wait until the next time that fund is priced (end of the trading day) before the transaction occurs. ETFs can be bought or sold throughout the day. You can buy an ETF in the morning and sell it in the afternoon. It may not be a great long-term strategy, but it is allowed.
Taxable Gains – Each year, mutual funds distribute any capital gains that occurred within the fund. These gains could potentially be short term which would be taxed at your ordinary income tax rate. That means that if you own a mutual fund in a taxable account, it may result in extra income even if you didn’t sell the fund. A good strategy is to hold ETFs in your taxable accounts and mutual funds in your tax deferred accounts such as IRAs.
Fees – ETFs usually charge less in fees. Mutual funds cost more to run and manage. In using our Vanguard funds above as examples; the mutual fund charges 0.18% annually, but the ETF charges 0.06% annually. That doesn’t sound like a big difference, but that is 66% less in fees. These little changes can make a big difference in your overall success.
Why not all ETFs?
If you are a passive investor with a long time horizon, it may be the best option. One bad thing with ETFs is that you must pay a commission when you buy or sell them. Many mutual funds offer buying and selling with no fees. Also, there is the risk is human nature. ETFs could be bought or sold at prices different that the value of the holdings. If investors panic and sell these ETFs in a frenzy, the actual value of the holdings in the company may not properly reflect the value it is trading at. It’s a rare scenario that usually adjusts at the end of the day, but it can damage long term returns for investors that trade ETFs like stocks. One other thing to remember is that many ETFs are created to invest in certain types of companies or sectors (airlines, oil, technology, etc.). You need to be more aware of the investment objectives when you buy ETFs.
The important thing is to understand the investments that you have in your portfolio. Look at the funds you own and make sure that there aren’t better options. If you work with a financial advisor, ask him/her why you are invested in each mutual fund or ETF in your accounts. If they are unable to explain it to you in a way that you understand and feel comfortable with the choices, get a new advisor because investing doesn’t have to be complicated to be successful.
Mike Zeiter, CPA/PFS