When investing in stocks and bonds, you have two main options: You can buy the shares of individual companies or individual bond issuers, or you can purchase stocks and bonds through mutual funds or exchange traded funds (ETFs).
Based on Frontier’s findings, many investors opt for mutual funds or ETFs. These provide a high degree of diversification because one fund may invest in hundreds or even thousands of individual stocks or bonds. They also offer professional management: Funds are run by portfolio managers, which helps simplify the investment management process for you.
Similarities and Differences
While similar, we believe there are some key differences between ETFs and mutual funds that you should be aware of. One of the biggest differences is that ETFs are listed on major stock exchanges, so you need a brokerage account to buy and sell them. However, mutual funds shares are traded directly with the fund company, so you don’t need a brokerage account to buy and sell them.
Another big difference is in the way that ETFs and mutual funds are traded and priced. ETFs are traded throughout the day and their prices fluctuate during the day, just like common stocks. Conversely, mutual fund shares are priced at the end of the day after the markets have closed, at which time the fund’s net asset value (NAV) is determined. Also, like stocks, ETFs can be sold short.
From a cost standpoint, ETFs usually feature lower expenses since they are passively managed index funds. The expense ratios of the more than 1,900 available ETFs range from about .10% to 1.25%, while the expense ratios for actively managed mutual funds can run as high as 8.5%. And ETFs are free of broker loads.
Taxes and Investing Styles
Frontier tends to view ETFs as being more tax-efficient than actively managed mutual funds. This is because as index funds, ETFs feature low turnover and thus don’t generate as much in the way of taxable capital gains. Also, ETFs do not have to sell securities in order to raise cash to meet investors’ redemption requests like mutual funds do, which further reduces taxable capital gains.
Finally, if you prefer active investment management over passive management, then you will probably opt for mutual funds. This is because, as noted above, ETFs are passively managed index funds.
There is a lot of healthy debate in the investment community about whether active or passive investing is a better strategy. We won’t get into that debate here, other than to point out that if you are an active investor, mutual funds — not ETFs — will usually be your investment vehicle of choice.
Room for Both?
Depending on your investing goals, there may be a place for both mutual funds and ETFs in your portfolio. Please contact us if you have more questions about the potential role of mutual funds and/or ETFs as part of your overall investing strategy.