What are ETFs and Mutual Funds?
Exchange-traded funds (ETFs) and mutual funds are both types of funds that allow investors to diversify their portfolios by investing in a variety of assets. While mutual funds are managed by a fund manager, ETFs are traded on a stock exchange like stocks. Mutual funds are typically bought and sold throughout the day, while ETFs are traded only when the stock market is open. ETFs and mutual funds can be used to build a core portfolio that represents a mix of stocks, bonds, and other assets that are expected to perform well over time regardless of economic conditions. While there are some key differences between ETFs and mutual funds, the main thing to keep in mind is that all investments come with risk. So while these funds can help you diversify your portfolio, they’re not guaranteed to grow your investment. Be sure you understand the risk involved before investing any money.
Benefits of ETFs
When comparing ETFs vs mutual funds, one of the primary benefits of ETFs is that they are tax-efficient. With a mutual fund, if you sell shares after holding them for a year or less, you will incur short-term capital gains taxes on the sale. If you hold those same shares for longer than a year, you will incur long-term capital gains taxes. With an ETF, you will incur short-term capital gains taxes regardless of how long you hold the investment. Mutual funds also charge deferred sales charges (DSC), which ETFs do not. These sales charges are usually around 5%, which can add up to significant over time especially if you hold the investment for a long time. In addition to being more tax-efficient, ETFs are also significantly cheaper to buy and sell than mutual funds. This is mainly because ETFs are bought and sold on an exchange and don’t have management fees associated with them. Mutual funds, on the other hand, are sold through a financial advisor, and the management fee covers the cost of managing the fund.
Benefits of Mutual Funds
Mutual funds offer more customization than ETFs, since you can choose from a variety of funds within the fund. With ETFs, you are limited to investing in the fund that it tracks. There are also no-load funds available, meaning you will not incur any sales charges when purchasing shares. You can also take advantage of active management with mutual funds, which is something you don’t get with ETFs. Active management can help take advantage of investment opportunities and can mean higher returns, although it also comes with a higher level of risk. Another benefit of investing in mutual funds vs ETFs is that they can be held in IRAs. While some ETFs are held in IRAs, they are not as common as mutual funds. If you’re trying to save for retirement, you can typically put up to $6,000 per year into a Roth IRA. Mutual funds are typically held in a taxable account, although some funds are available in a Roth account. If you are hoping to save for retirement, then a Roth account may be a better option since you won’t have to pay taxes on the earnings.
Drawbacks of ETFs
One of the drawbacks of ETFs is that you are limited to investing in the fund that it tracks. So if you see an interesting stock that you’d like to invest in, but it isn’t an ETF, you’ll have to look for another way to invest in that stock. Some ETFs are leveraged, which can be risky because they can magnify the amount that you earn or lose. Leveraged ETFs can be used as short-term trading vehicles, but they aren’t a good fit for investing in a long-term core portfolio. While there are many benefits to investing in ETFs, they don’t come without risk. Some of the risks associated with investing in ETFs include a rise in interest rates, a highly volatile market, and high levels of market risk.
Drawbacks of Mutual Funds
The most significant drawback of mutual funds is the higher level of risk that they carry. While the risk with ETFs is relatively low, mutual funds are much riskier and can carry a higher level of risk. Mutual funds can also be expensive since most of them charge a management fee. Mutual funds also tend to be less tax-efficient than ETFs. Since you can buy and sell mutual funds at any time during the day, you will incur short-term capital gains taxes on any gains. You can avoid paying long-term capital gains taxes if you hold the investment for a year or longer. Mutual funds also charge a deferred sales charge (DSC) that is typically 5%. This can add up over time, especially if you hold the investment for long periods.
Comparing ETFs vs Mutual Funds
Like any investment, it’s important to consider the potential risks and rewards associated with ETFs and mutual funds. When comparing ETFs vs mutual funds, one of the biggest factors to consider is a risk. The risk associated with ETFs is generally lower than that of mutual funds. Both types of funds can help you diversify your portfolio and gain exposure to a variety of different assets, but they come with different levels of risk and cost. While the risk with ETFs is lower, the costs associated with buying and selling shares are also much lower than that of mutual funds. In addition to cost, there are some key differences between ETFs and mutual funds that investors should be aware of. While there are some advantages to both investment vehicles, it’s important to consider your financial goals and objectives when deciding which option is best for you.
How to Choose an ETF or Mutual Fund
Since there are some advantages and disadvantages to both ETFs and mutual funds, you should determine what your financial goals are before choosing a fund.