3 Reasons To Consider Using ETFs Vs. Mutual Funds
How An ETF Investment Strategy Can Be More Lucrative To Your Bottom Line
When I meet with new or prospective clients, we talk about an investment strategy that is right for their particular circumstance. Oftentimes, I get the question, “how do you feel about mutual funds?”
The answer to that question is that it depends. I don’t necessarily dislike mutual funds, and there are some particular funds that I like very much. However, whenever possible, I’d rather use Exchange Traded Funds (ETSs) vs. mutual funds.
If you are new to the world of investing, it might be helpful to give you a primer on the two different types of investments. ETFs are investment funds that are traded daily on stock exchanges, much like stocks. ETFs can be thought of a basket of stocks, bonds, or commodities that track an index. For example, one well known ETF is DVY, the i-Shares Select Dividend. This ETF seeks to track the investment results of the Dow Jones U.S. Select Dividend Index which is composed of relatively high dividend paying U.S. equities.
Mutual funds work a little differently. This investment strategy pools your money together with other investors to purchase a collection of stocks, bonds, or other securities, known as a portfolio. Instead of trading on an exchange like an ETF, the price of the mutual fund, also known as its net asset value (NAV), is determined by the total value of the securities in the portfolio, divided by the number of the fund’s outstanding shares.
This price fluctuates based on the value of the securities held by the portfolio at the end of each business day. Note that mutual fund investors do not actually own the securities in which the fund invests; they only own shares in the fund itself.
On face value, the two investments seem quite similar other than the way their prices are derived.
But there is a lot more underneath the surface that you will want to be aware of before you make your next big decision of ETF or mutual fund. Three of the most important factors to consider are the following:
The first major difference between ETFs and mutual funds are the startup costs. Because ETFs trade like stocks, investors can buy small portions of the investment, excluding investors from being held to an investment minimum. This might be particularly beneficial to investors who are just starting out.
On the other hand, mutual funds require an investment minimum, which could range from $1,000 to $10,000.
There are no restrictions regarding how often ETFs can be traded, and trades can be executed throughout the day. A holder of an ETF knows what the price of his or her ETF is every minute of the trading day, allowing for total transparency. This makes ETFs attractive to both passive and active investors.
Mutual funds don’t allow for any intraday trading, resulting in zero transparency throughout the day. A mutual fund’s price, the net asset value (NAV), is calculated only once a day after the stock market closes at 4 p.m.
3. Tax Implications
The next big difference between ETFs and mutual funds are the tax implications.
There are no real taxable events within ETFs. Because investors can buy and sell ETFs like stocks, their gains and losses are based directly on their trading.
Mutual funds work much differently. Fund managers are constantly re-balancing the funds by selling securities due to shareholder redemptions or to re-allocate assets. This makes sense, but here’s the catch: The sale of securities within the mutual fund portfolio creates capital gains for all the shareholders. The result? You will incur taxes from the sale of the securities, essentially taking on the tax burden of other shareholders. You probably aren’t happy with your own tax bill — why would you ever want to take on someone else’s?
The Bottom Line
Every person has a different set of personal circumstances, and there is no “one size fits all” in the world of investing.
Just remember that knowledge is power and doing your homework on your investments is critical.
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Disclosure: This information is provided to you as a resource for informational purposes only. It is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal. This information is not intended to, and should not, form a primary basis for any investment decision that you may make. Always consult your own legal, tax or investment advisor before making any investment/tax/estate/financial planning considerations or decisions.