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The New Fund-amentals: ETFs and Mutual Funds

Jun 19, 2018

Key Takeaways

  • Mutual funds and exchange-traded funds (ETFs) can make it easy for investors to diversify among hundreds or thousands of stocks, bonds or other securities.
  • ETFs trade all day and mostly mirror “indexes,” keeping costs (and taxes) down and liquidity up.
  • Mutual funds can earn their keep when they outperform the market or their peers. However, there is no guarantee.


For decades, the average investor was able to put money in all corners of “the market” through mutual funds — professionally managed bundles of stocks, bonds and other securities that pool money from thousands of investors. Using diversification, they “spread risk” among dozens of and often hundreds of investments at a time so if some investments start taking on water the others are likely staying afloat helping prevent the whole portfolio from sinking.  This helped mutual funds became a staple of many workplace retirement plans, IRAs and self-directed brokerage accounts

 

 

Then, on New Year’s Day in 1993, an itsy-bitsy basket of stocks called SPDR crawled up the investment spout — and started spinning a web that recently begun to capture investors of all stripes. That’s because SPDR, an eight-legged acronym for “S&P 500 Depositary Receipt,” was the first of a new breed of investments known as exchange-traded funds, or ETFs.

Today more than 2,000 ETFs compete for attention with more than 9,000 mutual funds. The key difference lies in how investors buy and sell: ETF shares trade on exchanges during market hours, while mutual fund shares are bought from and sold by their providers once a day, after the market closes.

Investors may want to consider having both in their portfolios. Understanding the similarities and differences can help you determine which kind of fund, and which kinds of each, may be right for you.

Here’s a quick comparison of some key factors to consider.

 

Key Factors of ETFs and Mutual Funds
Key Factors ETFs Mutual Funds
Focus Collections of stocks, bonds or other securities that trade on exchanges such as the New York Stock Exchange. Prices can change throughout the day based on supply and demand. Most ETFs aim to mirror “indexes” that track specific types of investments or market segments. Collections of stocks, bonds or other securities typically bought and sold from the fund providers directly or through brokerage or other investment accounts. Most mutual funds are “managed” — they choose investments based on a stated investing “style” or strategy. Some, like target-date funds, follow a “glidepath” — a schedule of when to buy and sell certain kinds of investments.
Liquidity ETF shares trade throughout the day, and those that track large indexes are highly liquid, aka easy to buy and sell. This makes ETFs popular with “day traders” who buy and sell by the minute. Funds that focus on certain kinds of bonds or obscure markets, can be harder to sell, at least at a specific price. You can place an order anytime, but mutual funds are bought and sold after the market closes, at the day’s final “net asset value” or price per share. While it’s usuallly easy to buy and sell shares, exact prices can be hard to predict.
Costs Most ETFs aim to match popular indexes, so their operating costs (and investor charges) are usually very low. And for day traders, an ETF’s “bid/ask spread” — the gap between how much buyers are willing to pay and sellers are willing to accept — can make a big difference in the final cost of trading shares. “Actively managed” funds that don’t levy sales “loads” or other fees still charge annual operating expenses that take a (sometimes big) bite out of your returns over time. You get what you pay for — unless you don’t.
Tax Efficiency ETFs and mutual funds generate taxable capital gains when they sell securities whose prices have risen, but ETFs usually trade shares “in-kind” with other investors (mutual funds sell shares for cash). So in general, ETFs generate less capital gains than mutual funds do on the same securities. (Also, most ETFs buy and sell just enough to keep matching the index they track.) When a mutual fund investor redeems shares, the fund must sell the shares for cash, which often generates capital gains the fund pays out to shareholders at the end of the year. That’s on top of any gains the investor may see if they sell their fund shares for more than they paid.
Transparency Most “index” ETFs disclose their holdings online every day (“managed” ETFs are legally required to) — and every ETF must publish daily lists of securities it’s authorized to buy or sell. Mutual funds must report on their holdings once a quarter — with data that are 30 days old. Details aren’t so clear in the interim. Yet because mutual funds can “drift,” stray from their strategies, investors should monitor their funds’ holdings periodically.
Track Record Most ETFs aim to mirror indexes — benchmarks that track often narrow market segments that could be affected by things like interest rates, business cycles and investor attitudes. But except for long-term trends, you shouldn’t put much stock in how a stock or bond index has performed in the past. Some investments can be harder to master than others, and some mutual fund managers are that good at finding hidden gems or beating their peers or benchmark indexes. So, it can pay to pay attention to past performance — however past performance is not guarantee of future results.

 

Past performance is not a guarantee of future results or success and diversification does not assure a profit or protect against a loss in declining markets.

 


Remember that investing involves risk and it is possible to lose move when investing. Some investments have more risk than others. The risks associated are fully explained in each respective prospectus or summary prospectus. Please read the prospectus carefully before investing.

 

 

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