Mutual Funds and Exchange Traded Funds are basically the same investing option with a few important differences. Mutual Funds were created to offer regular investors access to the kind of expertise and diversification that only the rich enjoyed in the early days of investing. Exchange Traded Funds came around much later to lower fees and provide the advantage of stock-like trading.
Mutual Funds: A History of American Dreams
Mutual funds are just a collection of investments packaged together and managed for the investor’s convenience. For this convenience, investors pay a fee every year to the fund’s managers. Funds have been around for centuries but really came to market in the 1950’s and exploded in popularity over the last several decades.
Before mutual funds, access to the stock market was limited to those with the time available to analyze all the possible investment choices. Advisors and brokers were not as numerous or normally willing to take on clients without sizeable fortunes. Without the regulation and oversight we have today, this level of analysis was nearly impossible for the general public.
The vast majority of the population was doomed to park their savings in bank accounts and had little hope for wealth creation.
Mutual funds changed all this and there are now thousands of options for the investing public. The first funds were fairly basic and unorganized, just a mix of investments at the discretion of the manager. Virtually every investment style and index is now covered by a fund, some actively managed and others that are more passively-managed.
More than 7,000 Funds, which one is right for me?
It can seem nearly impossible to find the best mutual fund to fit your needs. You may even want to invest in a few different funds, much the same way that investing in different stocks provides diversification.
Fees are one of the most important things to watch for in fund selection. Annual management fees normally range from 0.2% to 2% and are calculated as a percentage of your total investment. Many types of mutual funds may also include fees that you pay with each contribution or when you sell the investments. Obviously, lower is better for fees and you should always compare fees for mutual funds across a few funds within the same investment category. Fees on mutual funds are such an important, and often misunderstood, topic that the Securities and Exchange Commission (SEC) has dedicated a page to help investors.
The real risk to mutual funds investment selection is that many advisors have hidden motives behind the advice they offer. Many mutual fund companies pay advisors for guiding investors to their funds so you may only be shown those funds that pay the highest kickback to the advisor. If you decide to let an advisor help you select a fund, always talk to a couple of different advisors to get the complete picture.
If you decide to select your own funds, look for the investment styles that meet your needs. Index funds generally just invest in a broad category and carry the lowest fees. There are also funds that invest in specific sectors, company sizes, along with a myriad of investment rules. A newer option is funds that target a specific date in the future and are designed to match the investor’s portfolio with the time they have to retirement.
ETF Investing: The New Kid on the Block
Exchange-traded Funds (ETFs) have been available since 1993 in the United States and were created to address many of the problems with mutual funds. ETFs basically run off of the same idea as mutual funds, a collection of investments packaged as one product, but trade like any other stock in the market.
Because ETF funds trade like stocks throughout the day on the market, you get an immediate price when you buy or sell. This isn’t the case for mutual funds which only trade at the market close. You put in an order for a mutual fund and the price could change dramatically before that order is filled.
ETFs are also generally less expensive than mutual funds. You will pay a transaction fee to buy or sell, just as you would any other stock but these are usually much lower than the percentage fees you pay to buy or sell a fund. The annual administrative fees for mutual funds are usually higher than comparable ETFs as well, about 1% more on average.
Taxes can be a huge drag for mutual fund investors. Because of the way the funds are set up, the constant buying and selling within the fund creates a taxable event for investors. That means you could be paying taxes on the fund’s gain every year whether you sold any of the investment yourself. With ETFs you only have to pay taxes when you personally sell the investment.
Do I still need mutual funds?
Because ETFs are generally traded like stocks and are not as actively sold to investors, they often do not come with the same level of advice and assistance as mutual funds. For this reason, some investors still seek the advice of advisors and buy into mutual funds. They may end up paying more in fees and taxes but can rely more heavily on advice from an expert.
A related caveat to ETF investing is that you need to understand how the fund chooses investments and decide whether it suits your needs for return. Many funds invest indiscriminately in the largest stocks in the market. This market-cap investing is not based on any valuation thesis or prospect for growth but simply a basket of the largest companies.
Despite their drawbacks, it does pay to have some mutual funds in your portfolio. Look those with low expenses and seasoned professionals managing the investments. The PIMCO Total Return Fund (PRADX), managed by bond guru Bill Gross, is among the most popular. The fund has a great long-term track record and invests in mostly bond investments which should help to lower the risk in your overall portfolio.
I am a big proponent in ETF investing and use the funds to round out my own portfolio. A few diversified funds can really lower the risk in a portfolio of individual stocks poised for growth. Look for funds with lower expense ratios and that provide the diversification you need against other investments.