Is one better than the other? It depends on a variety of factors, such as what type of investment you’re looking for and how you plan to invest. Here’s how to decide which investment vehicle may be right for you.
Exchange traded funds: the newer kids on the block
ETFs have been on fire in recent years. While their assets still pale in comparison to that of mutual funds, investors have been favoring ETFs over mutual funds in new investments. For example, in the first five months of 2017, assets in ETFs rose by $6.1 billion, according to the Investment Company InstituteOpens in a new window . At the same time, investors withdrew $8.5 billionOpens in a new window from mutual funds.
It’s not hard to see what investors like about ETFs. The biggest attraction is how cheap they are. Since ETFs are closely associated with index funds (though some actively managed ETFs have come to market in recent years), they are able to keep their costs down. There’s no need to pay expensive humans to pick securities, or analysts to research them.
And ETFs are tax-efficient. They do not have to distribute their capital gains, so you only pay gains when you sell your shares.
But there’s another reason ETFs are tax-efficient: how shares are created and redeemed. When a mutual fund shareholder sells his or her shares, the fund has to sell some of their holdings to raise the funds for the redemption, which could result in a gain.
But ETFs do not sell their shares into the open market. Instead, when an investor wants to sell, he or she is able to receive the underlying shares rather than cash. While that practice is typically available only to large institutional shareholders, such as pension funds or endowments, it benefits all shareholders because the fund itself isn’t selling shares for a possible gain.
Watch for the downsides
Though ETFs have a lot going for them, there are some features to bear in mind.
ETFs trade on an exchange, much like a stock. While that means you can buy and sell shares immediately, it also means you could be charged a commission by your brokerage firm. If you’re investing small amounts at regular intervals, that can add up.
Additionally, this ability to engage in intraday trading could encourage short-term behaviors. Investors should consider thinking about their money with a horizon of at least five years. Having the ability to trade throughout the day, and take advantage of changing prices, could cause rash decision-making, which may cut into your gains over time. Research, including a study by academics Brad M. Barber and Terrance Odean (“Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual InvestorsOpens in a new window”), has shown that the more people trade, the more their returns may be eroded.
Mutual funds: oldies but goodies
For half a century, mutual funds ruled the investing roost. They were the way most people were able to gain access to the markets. Their popularity really took off in the 1980s and ‘90s, as more companies moved from pensions to 401(k) plans. As individual investors made deposits into their 401(k)s, they invested the money in mutual funds.
Before the advent of discount brokers, mutual funds provided small investors with a cost-effective way to invest. Because mutual funds pool their money from a large number of investors, they are able to receive more-favorable pricing for trading securities typically reserved for large institutional investors. That enables small investors to hold positions that would otherwise be too cost prohibitive.
Within 401(k) plans, investors are able to buy mutual funds without commissions, which makes them an ideal vehicle for dollar-cost averaging, the practice of investing small amounts at regular intervals. Active managers still work mainly within the mutual fund structure, as they have the flexibility to invest where they see a potential upside. Having this ability to go where the opportunities might be can be especially important when markets are down.
There are disadvantages
But mutual funds have their limitations, including:
- Potentially high fees. Actively managed mutual funds have to charge more in order to pay their managers and research teams.
- End-of-day trades. It’s only possible to trade mutual funds once a day. Trades only go through after the market closes, and you can’t know what the price will be at that time. (On the other hand, this can discourage rash investor behavior based on short-term market moves.)
- Tax-inefficient. Mutual funds are required to pass on their capital gains to shareholders. So even if you don’t sell your shares during the year, you’ll be required to pay taxes on any gains the fund realizes.