A key component to smart investing is ensuring that your investments are diversified. Diversifying your portfolio incorporates a variety of different asset classes to reduce the volatility of your portfolio overtime. Mutual funds and exchange-traded stocks (ETFs) both serve this purpose while having unique features that differentiate them. Mutual funds have been around since 1924 while ETFs launched in 1993. A main component that separates the two is how they are traded. Mutual funds can only be purchased at the end of each trading day. The price of the mutual fund is determined by a calculation called the net asset value. However, ETFs can be bought at anytime throughout the trading day hours (9:30am to 4:00Pm Eastern time).
Mutual funds, in general, have a higher minimum investment requirement than ETFs. This minimum can range anywhere from a $250 initial deposit to funds that have a minimum investment of $3,000. Mutual funds typically have higher internal expenses than ETFs. The higher expense ratio with mutual funds is due to how they are managed. Many mutual funds are actively managed meaning that a team or a fund manager is actively making choices of buying and selling stocks in an attempt to try to beat the market. This takes significantly more effort than a passively managed fund whose investment securities are automatically selected to match an index.
Mutual funds can be split into two categories: Opened-Ended Funds and Close-End Funds. The majority of the mutual fund marketplace is occupied by open-ended funds. The number of shares the fund can issue is limitless. They can be bought and sold directly between investors and the fund company. Despite there being no limit on shares that can be issued, the value of an individual’s shares is not affected by the number of shares outstanding. Close-End Funds have only a specific number of shares and does not issue new shares even as investor demands increase. Net asset value (NAV) is not used in close-end funds to determine price. Instead, price of the fund is driven by investor demand.
Exchange-traded funds (ETFs) share a lot of similarities with mutual funds and individual stocks. From a price standpoint, ETFs can be as cheap as the price of one stock plus fees or commission. Also, ETFs can also be sold short just as a stock can. These funds possess many tax advatanages with one of them being delayed capital gains tax. Mutual funds pay capital gains tax while holding shares, but ETFs do not pay capital gains until the sale of the product.
ETFs separate themselves from other forms of investments with their creation/redemption process. The creation process is the buying of all the underlying securities and bundling them into the exchange fund structure. A specialist who is empowered to create or redeem ETF shares will buy the underlying securities and put them into a trust. The redeeming of an ETF is often referred to as “unwrapping” the ETF back into individual securities. It is the reverse process of the ETF creation. This process keeps the value of the ETF in line with its net asset value (NAV) so that it does not sell at a discount or premium.
In summary, both options are good investments. Each one offers specific advantages depending on what you are looking for out of your investment. If you want to short sell or are looking to intraday trades, ETFs would be an investment to look in to. If you want a fund that will try outperform the market by selecting what it believes are the right investments, an actively managed mutual fund could be the investment option for you. These goals and criteria are important to think about so that you can tell you financial planner what you are looking for. This will allow them to customize a plan and investments that will best suit your financial needs.
To discuss your specific investments and learn about more about Mutual Funds and ETFs please contact one of our Financial Advisors today!
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