The main idea behind ‘diversification’ is to effectively reduce risk. The technique allocates investments among an array of financial instruments, industries, and several other categories. Its intent is to maximize returns by way of investing in a variety of areas. Specifically, ones that would each react in a different manner to the same event.
Opinions vary, but there is one thing that a majority of investment professionals agree on. That being even though there’s no guarantee against loss, diversification is a crucial component in long-range financial goals. It helps reach them while also actively minimizing risk.
There are plenty of investors that are hoping to use this technique to diversify their stock and bond holdings. Moreover, they want to do so at a comparatively low cost. Oftentimes, they turn to the world of funds. To be specific, two types of funds: exchange-traded funds (ETFs) and mutual funds. ETFs, index mutual funds, and regulated mutual funds can provide broad, diverse exposure to multiple groups. Asset classes, regions, a specific market niche, the list goes on. Not only that but it’s without needing to purchase scores of individual securities.
There is a challenge here. You need to narrow down the type of investment that is suitable for you. You can choose either a conventional ETF that tracks an index or a low-cost index mutual fund. Alternatively, there is a new kind of ETF – a ‘fundamentally weighted index ETF’ – that could improve a portfolio’s risk-adjusted-performance. Or, perhaps, you would prefer a mutual fund with active management.
We tend to approach this as if ETFs and mutual funds are two completely different types of funds. In actuality, they share a good amount of similarities with only a few notable differences separating them.
What are ‘Exchange-Traded Funds’?
An ETF is a collection of securities that are actively tracking an underlying index. ETFs typically consist of an array of investment types including stocks, commodities, or bonds. In fact, they can even consist of a complete mixture of investment types. The standard ETF is marketable security, therefore it has a price that allows it to be easy to buy and sell.
ETFs usually cost less for an entry position; sometimes as little as the cost of one share, plus fees or commissions. The creation and redeeming of an ETF are in large lots by institutional investors and the shares trade. This process lasts throughout the day and between investors. This, above all else, is the source of one of their key strengths. Funds with passive management are prone to having lower costs than those with active management.
Similar to a stock, ETFs are capable of being sold short. Those provisions are critical to traders and speculators alike. However, they are of very little interest to investors that are more long-term. Because the pricing of ETFs is continuous by the market, there is a notable potential that comes with this. That being it could have trading occur at a price other than the true NAV (new asset value). This may introduce the opportunity for arbitrage.
ETFs offer investors plenty of tax advantages. Passively managed portfolios ETFs (as well as index funds) often attain fewer capital gains than those that are actively managed.
The three ETF types
In total, there are three legal classifications for ETFs:
- Exchange-Traded Open-End Index Mutual Fund. This fund is registered under the SEC’s Investment Company Act of 1940. Dividends undergo reinvestment on the day of receipt and payment towards the shareholders is in cash every quarter. Securities lending is permitted and it is possible to use derivatives in the fund.
- Exchange-Traded Unit Investment Trust (UIT). The governance of these ETFs is also by the Investment Company Act of 1940. However, these have to try to fully copy their specific indexes, limit investments in a single issue to 25% or less. What’s more, they must establish additional weighting limits for funds that are diverse and non-diverse. UITs do not automatically reinvest dividends, though they do pay cash dividends quarterly.
- Exchange-Traded Grantor Trust. This ETF bears an incredibly strong resemblance to a closed-ended fund. Regardless, an investor is the owner of the underlying shares in the companies that the ETF is invested in. This includes having voting rights in association with being a shareholder. Despite this, the composition of the fund changes very little. Dividends do not go through reinvestment, but the payment is direct to shareholders. It is mandatory for investors to trade in 100-share lots. Holding company depository receipts (HOLDRs) is a primary example of this specific ETF type.
What are Mutual Funds?
A mutual fund is a type of financial vehicle consisting of a pool of money from many investors. This money goes towards investing in securities such as stocks, bonds, money market instruments, and other types of assets.
The operation of mutual funds is in the hands of professional money managers. These people allocate the fund’s assets and make an effort to produce capital gains or income for the investors. These funds often come at a higher cost due to them requiring a lot more time, effort, and manpower. The structure and maintenance of a mutual fund’s portfolio match the investment objectives that its prospectus states.
Mutual funds provide individual or smaller investors proper access to portfolios with professional management. These portfolios pertain to equities, bonds, and various other securities. Therefore, each shareholder engages proportionally in the fund’s gains or losses. Mutual funds typically invest in an extensive amount of securities. Moreover, performances are tracked as the alteration in the total market cap of the fund. This derives largely from the aggregating performance of the latent investments.
Mutual funds will often come with a minimum investment requirement that is much higher than ETFs. Those minimums will usually vary depending on the type of fund and company. The Vanguard 500 Index Investor Fund, for example, requires a $3,000 minimum investment. Meanwhile, the Growth Fund of America that American Funds offers has a requirement of a $250 initial deposit.
The execution of purchases and sales of mutual funds is directly between investors and the fund. The determination of the price of the fund does not happen until the end of the business day. Specifically, when it comes time for determining the NAV.
The two types
Overall, there are two legal classifications for mutual funds:
- Open-Ended Funds. In the mutual fund marketplace, these funds are a dominating force in terms of volume and assets under management. With these funds, the purchase and sale of fund shares occur directly between investors and the fund company. There is no restriction on the number of shares that the fund is able to issue. Thus, as more investors buy into the fund, there is more issuance of shares. There is a requirement, according to federal regulations, for a specific daily valuation process. This is what is referred to as ‘marking to market’. It subsequently adjusts the fund’s per-share price to provide a reflection of changes in the value of the portfolio (asset). The number of shares outstanding does not affect the value of an individual’s shares.
- Closed-End Funds. These are funds that issue only a specific number of shares. What’s more, they do not issue new shares as investor demand continues to grow. The determination of prices is not by the NAV of the fund, however, they thrive off of investor demand. The purchases of shares are usually at a premium or discount to NAV.
So, how are these types of funds similar?
Now that we have gone over their formal definitions, we can proceed with explaining why these fund types are comparable. How does a collection of securities bear any similarities to a pool of money going towards security investment?
First and foremost, both ETFs and mutual funds are considerably less risky than investing in individual stocks and bonds. They are each accompanied by innate diversification. A single fund could include tens, hundreds, or thousands of individual stocks or bonds within one fund. If one stock or bond is displaying a poor performance, then chances are there is another is performing very well. That could assist in the dwindling of your risk and your losses as a whole.
Another similarity is that they both offer an array of investment options for those choosing to invest in them. ETFs and mutual funds provide complete access to a wide variety of U.S. and international stocks and bonds. You are able to invest in one of two ways:
- Broadly (ex. a total market fund)
- Narrowly (ex. a high-dividend stock fund or a sector fund)
Alternatively, you could invest anywhere in between. In the end, it all depends on your personal preferences, goals, and investing style.
Finally, the supervision of both ETFs and mutual funds is by professional portfolio managers. The management of both of these fund types is in the hands of experts. These professionals choose and keep an eye on the stocks or bonds that the funds invest in. This saves a lot of time and effort on your part. Admittedly, a majority of ETFs – and many mutual funds for that matter – are index funds. However, the portfolio manager is still present to make sure that the fund ceases to stray from its target index.
How are they different?
Now, when it comes to the differences between ETFs and mutual funds, there are some things you need to ask yourself. What you want as an investor is what basically highlights the distinctions between the two.
ETFs offer a more hands-on approach when it comes to controlling the price of your trade. Not only do they provide real-time pricing, but they also allow you to use more complex order types. Specifically, those that grant you the most control over your price. Keeping things simple is permitted, just so long as you stick with a market order. Mutual funds are different in that it doesn’t matter when you place your order. In the end, you will get the same price as everyone else who was buying and selling that day. There is no calculation of the price until following the trading day’s conclusion.
Mutual funds allow you to repeat specific transactions automatically. You are able to establish automatic investments and withdrawals into and out of mutual funds. This process draws its foundation from whatever your preferences may be. This is something that ETFs are unable to accomplish, thus making mutual funds a more suitable investment in this case.
When it comes to wanting lower investment minimums, ETFs have a much bigger advantage over mutual funds. You can purchase an ETF for the price of a single share. This is commonly referred to as the ETF’s ‘market price’. That price could often be as little as $50 or surpass an amount of a few hundred dollars. Really, it depends primarily on the ETF. Mutual fund minimum initial investments, on the other hand, do not draw from the fund’s share price. Instead, they are a flat dollar amount.
Why invest in ETFs
Generally speaking, ETFs are more tax efficient. This is largely due to their tendency of not distributing a whole lot of capital gains. The reason for this being tracking an index will not usually require frequent trading. ETFs may involve trading commissions, however, some brokerages offer ETFs that are free of commission.
You should consider investing in an ETF is the following applies to you:
- You are an active trader. Intraday trades, stop and limit orders, and short selling are all possible with ETFs. The same cannot be said for mutual funds.
- You want niche exposure. ETFs that focus on specific industries or commodities can grant exposure to particular market niches. On the whole, niche investing is not possible with index mutual funds. However, there is a chance that some niche funds with active management are available.
- You are tax-sensitive. ETFs and index mutual funds are comparatively more tax-efficient than funds with active management. In fact, ETFs are capable of being more tax-efficient than index funds.
Drawbacks for ETFs
It is important to remember the potential drawbacks that can come from ETFs. These include the following:
- There are lower dividend yields. As is the case with mutual funds, risks that come with owning an ETF are lower than with a stock or group of stocks. This means that the dividend yields are low as well. The reason for this is because ETFs track a broader market, therefore the overall yield ties to an average.
- Some ETFs have larger bid/ask spread. Whenever you purchase or sell ETF shares, the price they give you may be less than the underlying value of the ETF’s holdings. In other words, it will be less than NAV. Oftentimes, this discrepancy – which is the ‘bid-ask spread’ – is quite minuscule. However, for niche ETFs that do not receive a lot of trading activity, the spread can be wide.
- Be cautious of creeping fees. Individual trading fees are capable of adding up quickly whenever you are buying and selling ETFs. Moreover, that can ultimately diminish its performance. Make sure that you research what fees and commissions the provider charges for each trade.
Why invest in mutual funds
You should consider investing in a mutual fund with active management if the following pertains to you:
- You wish to have a fund that could potentially conquer the market. The primary reason as to why people invest in actively managed funds is one notable probability. That being they could possibly beat their benchmarks. However, it’s important to note that most are unable to do so at a consistent rate. In addition, active management with a specific plan of action may complement index funds in a portfolio. An example of this is the fact that some managers aim to cut down on downside risk and volatility.
- You are investing in a section of the market that is less efficient. There are some markets that many people see as being highly “efficient.” This basically means that the businesses or markets are incredibly popular and information undergoes quick and wide distribution. So much so that there is very little opportunity for active managers to add value. Large-cap U.S. stocks are a prime example of a market segment with great efficiency. Emerging market stocks or high-yield bonds are less efficient markets where extensive research and a solid strategy could pay off.
Drawbacks for mutual funds
Like with ETFs, there are potential drawbacks with investing in actively managed mutual funds. Take the following into consideration:
- There is a chance that they could underperform against an index. This is the alternative outcome of an actively managed funds’ potential of conquering the market. Furthermore, there is also the probable chance of it underperforming against the market.
- They will often have considerably higher fees. As you can easily tell by the name, actively managed funds have active management. Therefore, those managers will be establishing a fee with every adjustment they apply to the fund.
- They are, for the most part, less tax-efficient. These types of funds have a tendency to possess a higher tax cost than index funds. This is mostly because as a manager liquidates and purchases investments while trying to beat the market, there is a frequent realization of capital gains. As a result, those are taxed. The more activity there is in a fund, the more those taxes will inevitably add up.