Puzzled by the choices and benefits of ETFs vs mutual funds?
In my investment advisory practice, I typically use ETFs instead of mutual funds within a client’s investment portfolio.
While ETFs are increasing in popularity, I have noticed investors don’t always know the benefits of ETFs over mutual funds.
What Are ETFs?
The best way to explain ETFs is to compare them with a traditional index mutual fund — like the Vanguard S&P 500 Index Fund (“VFINX”).
To start, let’s define the term “index”:
What Is An Index?
A statistical measure of change in an economy or a securities market. In the case of financial markets, an index is an imaginary portfolio of securities representing a particular market or a portion of it. Each index has its own calculation methodology and is usually expressed in terms of a change from a base value. Thus, the percentage change is more important than the actual numeric value.
Stock and bond market indices are used to construct index mutual funds and exchange-traded funds (ETFs) whose portfolios mirror the components of the index.
Since indices are imaginary portfolios, firms (such as Vanguard, Fidelity, iShares and others) create investment products that aim to replicate specific indices.
Like an index mutual fund, ETFs seek to replicate a specific index, such as the S&P 500 Index. In addition, ETFs can replicate a basket of assets like stocks, bonds, commodities, etc.
ETFs can provide numerous benefits for investors when they are creating and managing their investment portfolio.
How Do ETFs Work?
ETFs are similar to index mutual funds in that they are created to replicate an index or strategy, except that ETFs are listed, bought and sold on a stock exchange like the NYSE or American Stock Exchange.
ETFs allows individuals to invest in a portfolio of securities that provide the same diversification
benefits of mutual funds with the liquidity and trading flexibility of stocks.
For example, when you purchase a mutual fund in the middle of the day, the actual price per mutual fund share is calculated at the end of the day. Unlike ETFs, which are priced in real time.
In other words, if you were worried about a deep, intraday decline in the stock market, ETFs allow you to sell your shares at anytime of the trading day.
If you were to sell your mutual fund in the same scenario, the price you would receive is the end of day price — even if you sold your mutual fund before any steep declines that might have taken place during the trading day.
Types Of ETFs
|Market ETFs||Designed to track a particular index like the S&P 500 or NASDAQ.|
|Bond ETFs||Designed to provide exposure to virtually every type of bond available; U.S. Treasury, Corporate, Municipal, International, High Yield and several more|
|Sector and Industry ETFs||Designed to provide exposure to a particular industry, such as oil, pharmaceuticals, or high technology.|
|Commodity ETFs||Designed to track the price of a commodity, such as gold, oil, or corn.|
|Style ETFs||Designed to track an investment style or market capitalization focus, such as large-cap value or small –cap growth.|
|Foreign Market ETFs||Designed to track non-U.S. markets, such as Japan’s Nikkei Index or Hong Kong’s Hang Seng index|
|Inverse ETFs||Designed to profit from a decline in the underlying market or index.|
|Actively Managed ETFs||While most ETFs are designed to track an index, actively managed ETFs are designed to outperform an index.|
|Exchange Traded Notes||Exchange Traded Notes are in essence debt securities backed by the creditworthiness of the issuing bank. They were created to provide access to illiquid markets and have the added benefit of generating virtually no short-term capital gains taxes.|
|Alternative Investment ETFs||Innovative structures, such as ETFs that allow investors to trade volatility or gain exposure to a particular investment strategy, such as currency carry or covered call writing.|
Top Benefits of ETFs vs Mutual Funds: Pros and Cons
Some of the main benefits ETFs have over mutual funds include:
–Buy and sell any time of the day: Mutual funds, in contrast, settle after the market close.
–Lower fees: There is no sales load like on many mutual funds, however, brokerage commissions do apply.
–More tax efficient: Investors have better control over when they pay capital gains tax.
–Trading transactions: Because they are traded like stocks, investors can place a variety of types of orders (limit orders, stop-loss order, buy on margin) which are not possible with mutual funds.
While superior to mutual funds in many respects, ETFs do have drawbacks, including:
–Trading costs: If you invest small amounts frequently, there may be lower-cost alternatives investing directly with a fund company in a no-load fund.
–Illiquidity: Some thinly traded ETFs have wide bid/ask spreads, which means you’ll be buying at the high price of the spread and selling at the low price of the spread.
–Tracking error: While ETFs generally track their underlying index fairly well, technical issues can create discrepancies.
Feel free to leave a comment below or you can reach out to me privately here.
PS: If you found this article interesting, please feel free to share it. Thanks!