I want to retire when I am 65. Should my retirement portfolio be invested in mutual funds or exchange-traded funds i.e. ETFs? We get that question quite a bit. Perhaps some history will help.
The first mutual fund was launched in 1924, the Massachusetts Investors Trust (MITTX). Mutual funds provide investors, daily liquidity, broad diversification, professional management, and presumptively low cost. In the last 70 years the investment landscape has changed dramatically.
One innovation is exchange-traded funds (ETF) which were first developed to provide access to passive indexed funds to individual investors. Since their inception in the 1990’s, the number of ETFs has grown tremendously.
Mutual funds and ETFs are similar in that they are both buckets of stocks and bonds that allow the individual investor to participate in the market without having to handpick individual underlying stocks and bonds. Mutual funds and ETFs can have a combination of the same assets, consequently, their performance can be very similar.
What are the key differences between mutual funds and ETFs?
Liquidity & Trading: The big difference between traditional mutual funds and ETFs is their trading flexibility. Mutual funds can only be bought and sold once daily, at the end of the trading day. ETFs trade throughout the day like stocks.
ETFs tend to have a lower total expense ratio than competing mutual funds. ETFs do not charge 12b-1 fees and have lower management and operating expenses. In general, ETF cost less to invest than mutual funds if held for the long term. Annual expense ratios of 1-2% are common in mutual funds, while ETF expense ratios are usually 0.5% annually. This cost-saving is passed onto the investor.
Active management vs. passive management:
How a fund actually invests has a lot to do with your costs and potential returns. Some funds engage in what’s called active management in which the fund’s manager picks and chooses stocks to buy and sell and when to do so. This approach is more typical for mutual funds.
The other approach is called passive investing, and it’s where the fund manager doesn’t select the investments but rather mimics an index or asset class that’s already been selected, such as the S&P 500. This approach is more typical of ETFs, although ETFs may sometimes be actively managed.
ETFs are more tax-efficient compared to traditional mutual funds. Generally, holding an ETF in a taxable account will generate fewer tax liabilities than if you held a similarly structured mutual fund in the same account. This is due to the structural differences. Mutual funds typically incur more capital gains tax than ETFs. Capital gains tax on an ETF is incurred only upon the sale of the ETF by the investor. Mutual funds pass on capital gains taxes to the investors throughout the life of the investment.
Neither mutual funds nor ETFs are perfect. Both can offer solid exposure at minimal costs and can be good tools for investors. Passively managed ETFs have clear advantages over mutual funds. They have lower expense ratios, trade for free and are more tax efficient.
- Mitchell Ewart
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Diversification seeks to reduce volatility by spreading your investment dollars into various asset classes to add balance to your portfolio. Using this methodology, however, does not guarantee a profit or protection from loss in a declining market.