November 30, 2016
For many investors, deciding between a mutual fund or an exchange- traded fund as the preferred investment method can be a confusing process.
“The decision is largely philosophical,” says Eric Hutchinson, a managing director at United Capital in Little Rock, Arkansas. “It should be based on your goals, objectives and comfort level with each option.”
Many financial experts say investors should start by deciding if they want to have their investments to be actively or passively managed . Keep in mind, ETFs and mutual funds both offer active and passive strategies, although mutual funds have significantly more actively managed funds, says Gabriel Pincus, president of GA Pincus Funds in Dallas.
Both are baskets of stocks and offer relatively low-cost ways to assemble a highly diversified portfolio in a single purchase, Hutchinson says. Mutual funds set their price once a day and are overseen by fund managers while ETFs mirror an index — like the Standard & Poor’s 500 index — and trade like stocks do, which means they can easily be bought and sold throughout the day, not just at the end of the day.
While most mutual funds have a fund manager who is actively picking stocks or bonds to try and beat a benchmark — an index the manager tracks — ETFs are usually passively managed, geared towards do-it- yourselfers who want to track the return of an index.
“With mutual funds, the investor is hiring a fund manager to make active investment decisions, with a long-term goal of outperforming a certain benchmark,” says Mitch Zacks, president of Zacks Investment Management in Chicago. “An ETF (typically) does not have an active manager at the helm, and instead of trying to outperform a benchmark, its goal is simply to mimic it.”
If an investor’s goal is to track the performance of an index, an ETF structured to mirror the chosen index may be the way to go, Hutchinson says. “You will not likely ever outperform the index with the ETF-mirror approach, but you will always have performance that fairly closely tracks the index,” he says. “If you want to outperform an index, an active management strategy may be your only chance to achieve that outperformance.”
Historyandtrends.Mutual funds began hundreds of years ago, but the first mutual fund in the U.S. was launched by Massachusetts Investors Trust in 1924. Nearly 70 years later, State Street Global Advisors launched the first ETF with its SPDR fund (ticker: SPY) in 1993.
Since then ETFs have become increasingly popular . According to Investment Company Institute, there are $16.35 trillion in assets in mutual funds and $2.39 trillion in assets in ETFs within U.S.-based (SEC- registered) funds that also invest globally. That’s a $431.60 billion– 22.1 percent increase — in ETFs over a 12-month period.
Pincus says the shift is happening because very few active managers actually outperform their benchmarks and many lose to their benchmarks quite consistently.
“It’s happening because the markets have become more efficient,” Pincus says. “It’s very hard to outperform an index these days. Years ago when spreads were wider and information moved more slowly, it was easier and people could outperform the index. Now that everyone has the same information, it’s very difficult.”
The other reason: the amount of money being invested. Think of investment managers as commercial fishermen. In the past they were trying to find “fish” in a pond and now they are searching in an ocean. “You’ve got to find winning picks when you are a manager,” Pincus says.
“If a fund is too large, it becomes difficult to select winners without influencing the direction of the market.”
Other considerations. Based on its self-directed structure, ETFs offer more tax efficiency than most mutual funds, says Anthony D. Criscuolo, a certified financial planner and portfolio manager with Palisades Hudson Financial Group in Fort Lauderdale, Florida. Some mutual funds also have relatively high investment minimums, which ETFs do not.
“While some investors assume ETFs will always be cheaper than mutual funds, this is not necessarily the case,” Criscuolo says. “In addition to the expense ratio, investors should carefully consider the other costs of each type of fund. It’s just as important to pay attention to an ETF’s brokerage fees as it is to understand a mutual fund’s load, if any, and other fees.”
Fees for mutual funds generally range between 1 to 2 percent,
whereas ETFs are generally less than 1 percent because investors have more responsibilities on making choices, Zacks says.
For investors who are concerned about capital gains and controlling the impact of additional, taxable income, Hutchinson says ETFs typically offer more control to investors of when to buy and sell based on the investing vehicle’s self-directed structure. Since mutual funds are usually actively managed, it can cause capital gains to be recognized and distributed at times that may or may not be advantageous to an individual investor, Hutchinson says.
John H. Foard III, CEO and founder of Foard Wealth Management in Charlotte, North Carolina, says investors need to be wary of pass-through taxation. Investors will not realize any capital gains on an ETF until they sell, while an investor may realize capital gains and losses during the year without selling at mutual fund.
For example, consider an investor who buys into a mutual fund after the fund manager had already purchased Apple ( AAPL ) stock at $50 and later sells it for a gain once it hits $100 a share. “Even though you bought into the fund after the gain you are still beholden to pay your fair share of the capital gains tax,” he says. “You have zero control. It’s up to the discretion of the fund manager, even if you don’t participate in the gain.”
Foard says he’s had clients receive 1099 tax forms for capital gains on investments they never they saw and lost money on the fund. “I had a client who put $10,000 in the fund, the year finishes and in January the fund is only worth $9,000 and they still get a 1099 for a capital gains inside the fund,” Foard says.
Still, Foard says there is a place for mutual funds. “Mutual funds were designed for instant diversification all at once,” he says. “It’s still an attractive investing avenue if you have less than $100,000 and it’s great for folks who can only do $50 a month. That’s why people still flock to the mutual fund industry. But if you have more money, especially if you have more than $250,000, you are better off with a customizable portfolio with individual stock purchases.”
Dawn Reiss is an award-winning journalist in Chicago who has written for TIME, Reuters, Chicago Tribune, The Atlantic and Travel + Leisure and many other publications. Follow her on Twitter, Google+ and Instagram @dawnreiss.