Let's Compare Exchange Traded Funds, ETF funds, and Mutual Funds. Which Investment Makes More Money for the Small Investor?
Exchange Traded Funds, also called ETF funds, and mutual funds both offer investors an easy and low-cost way to purchase a diversified portfolio that reflects a particular investment objective. Because ETF funds make more money on average, are easy to trade, have lower fees and better transparency, the small investor may very well prefer to hold ETF funds rather than mutual funds. Here the small investor will find 20 ways to compare ETF funds and mutual funds, with their similarities and differences. And will ETF funds ever replace mutual funds, you ask. You'll find the answer here, too.
Comparing ETF and Mutual Funds
- Let's Compare Exchange Traded Funds (ETF funds) and Mutual Funds. Which Investment Makes More Money for the Small Investor?
- 4 Top Popular Exchange Traded Funds ETF for the Small Investor, ETF Symbols GLD, SPY, DIA, SLV
- ETFs are Exchange Traded Funds for Investment
Purpose of the Fund. Mutual funds own a broad basket of securities. Index mutual funds and many ETF funds own a basket of securities that are chosen to mirror the performance of a major securities index. Both allow the small investor to diversify holdings among more companies and minimize risks. However, there are other ETF funds available for other types of investing.
- Compare Share Prices. Most mutual fund shares are bought and sold at their net asset value, or NAV, which is based on the value of the fund's underlying securities. These are organized as open-ended funds. For an ETF fund, the share price is set by trading prices on a stock exchange and closely follows its net asset value.
- Availability of Share Prices. The price of a share of an ETF Fund is available moment by moment as it trades on a stock exchange. The price of a mutual fund is published generally at the end of the day.
- Compare Which Makes More Money. Stock research shows that managed mutual funds on average underperform the funds that are not managed, index funds and ETF funds. In general, an ETF fund based on a broad stock index is likely to make more money for you.
- Asset Classes. You can choose among ETF funds that invest in securities of various sectors, including commodity, currency, equity, fixed income and global equity. For any investment index, there are probably ETF funds that track it. A class of leveraged ETF funds use debt to increase the volatility of the fund, so their results can double or triple the performance of the tracking index.
- How to Make Money. The small investor makes money from both a mutual fund and an ETF fund by selling his shares at a higher price than he paid for them. The mutual fund will also have capital gains when it trades in stocks and other securities. Either type of fund may also distribute any dividends earned on its holdings to the shareholder.
- Compare Annual Fees. Both mutual funds and ETF funds charge an annual expense fee that is deducted from the value of your shares. For the investor, a mutual fund has higher annual fees than an ETF fund. A managed mutual fund pays the fund manager a fee to select stocks. Annual management fees and expense fees can range from to 2% to 3% of the investor's money every year. ETF funds typically do not need a fund manager, so they have annual expense fees of .5% to 1%. Index Mutual Funds do not need a fund manager, so annual fees are also lower, from .5% to 1%. The fee is always disclosed in the prospectus.
- Fund Populartiy. More money is invested in mutual funds than in ETF funds. At this time, investors have $9 trillion in mutual funds, compared to $1 trillion in ETF funds. ETF funds are relatively new investment securities. Most have been launched since the 1990's.
- Loaded Funds. A few mutual funds charge a sales commission, a fee to purchase shares of the fund, called a front-end load. This one-time fee might be 5% of the amount invested, and is charged at the time the small investor buys the shares. There is never a front-end load when you buy shares of an ETF fund or when you buy shares of an Index Mutual Fund.
- Compare Transparency. An ETF fund or an Index Mutual Fund is simpler. You know exactly what securities the fund holds. The holdings do not change over time because the compositon of a financial index is stable. On the other hand, managed mutual funds do not disclose their trades or their holdings, except at the end of the quarter. As a small investor, you rely on the mutual fund manger to made investing decisions for you.
- Compare Portfolio Overlap. Many managed mutual funds hold some of the same securities. For example, many mutual funds own shares of Apple, AAPL. If the small investor buys shares of two such mutual funds, you may be doubling up on shares of some companies, and your portfolio is less diversified than you think. ETF funds which are linked to an investment index have specific, restricted holdings.
- Minimum Investment. Mutual funds require a minimum investment from the investor. Sometimes it is as low as $500, sometimes it is $10,000. ETF funds have no minimum investment. You can buy 1 share or 1000 shares of any ETF fund at the market price.
- Commission. The stockbroker who executes your ETF fund order charges a commission, the same as you pay for any stock trade. A typical commission charged by an online broker is $9.99, no matter how many shares you buy or sell.
- How to Buy. You buy mutual funds by contacting the managing investment company, for example, Vanguard or Fidelity. For your convenience, stockbrokers will handle your purchase of many mutual funds. To buy ETF funds, the investor should open an account with any stockbroker. Once your account is open and funded with your money, the stockbroker will execute your buy or sell order, just like any stock. Buying and selling ETF funds can be done online.
- Federal Income Tax. You pay federal income tax when you sell your shares of an ETF fund or a mutual fund. And the tax is based on the capital gain, the difference between the proceeds of the sale and your original cost.
- Tax on Capital Gains Distribution. When you own a mutual fund, you also have to pay income tax whenever the fund sells some of its holdings at a profit. Once a year, the mutual fund distributes its profits to the shareholder in the form of more shares in the fund. This event is called a capital gains distribution. The small investor receives no money, but gets a Form 1099 from the fund and has to pay federal income tax on the capital gain. It is ironic that the investor could have a capital gains tax to pay, even though the mutual fund has lost money overall during the year.
- Other tax considerations. For some mutual funds and ETF funds, when you sell your shares, the gains are taxed as ordinary income. The fund prospectus will disclose this for the small investor. These funds sometimes hold commodities or currency.
- Buying on Margin. The small investor who has a margin account with any stockbroker can buy ETF funds on margin. Generally mutual funds cannot be bought on margin. Buying on margin means that the stockbroker advances a portion of the money for the purchase, and charges the investor interest at the quoted rate.
- Day Trading Funds. Because ETF funds are traded on stock exchanges, the small investor can buy and sell as often as desired. Mutual funds cannot be traded during the day, because the share price of the mutual fund is published at the end of the day.
- Will ETF funds ever replace managed mutual funds? For the small investor, ETF funds should replace managed mutual funds in their portfolio. But will managed mutual funds die out? Hardly. Managed mutual funds can sometimes have a temporary hot streak that attracts new investors. Managed mutual funds will continue to be sold, as long as optomistic investors are willing to buy them.
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