Demystifying Mutual Funds and ETFs
by Manisha Thakor
Long-time readers of this blog know that as a financial advisor I’m passionate about helping women become more confident and excited about investing. That’s because in a world where it’s increasingly possible to live to 100, investing for the long run is a way to increase the odds that your hard-earned savings will grow enough to at least offset the corrosive power of inflation – and hopefully increase your purchasing power, too.
One of the things that can make investing so confusing is the sea of seemingly incomprehensible vocabulary used to describe your investment options. More and more frequently, I’m hearing people use the terms “Mutual Fund” and “ETF” interchangeably. While similar, these two types of investment vehicles have some key differences you’ll want to be aware of.
What are Mutual Funds and ETFs?
Simply put, mutual funds and ETFs are mixes of various investments such as stocks and bonds created by professional investors. You can think of them as financial smoothies. Rather than go out and buy the individual pieces of fruits and vegetables, you can buy a serving of a smoothie that someone else prepares.
In the financial world, that serving is called a share of a mutual fund or an ETF. The key benefits of these financial smoothies are diversification and professional oversight.
Which one is “better”?
The answer really depends upon what your investment strategy is. My personal opinion is that the vast majority of investors are best served by utilizing a diversified, low cost, long-term investment approach consisting of investment in index or passively oriented vehicles. If you concur with this (and not everyone will), mutual funds often make the most sense.
Mutual funds get priced at the end of the day (making them more appealing to long-term investors) and investors can easily purchase specific dollar amounts at regular intervals, often with minimal transaction costs. While the tax consequences of owning mutual funds are spread across all shareholders, if you are using passive funds, these costs will be minimal.
However, if you are planning to actively trade in and out of positions based on the latest news or want the ability to set a pre-determined price at which you’d want to buy or sell a security (aka “limit orders”) ETFs can make great sense. ETFs trade all day long, you can place limit orders (ie instructions to buy or sell at a specific price), and if you trade that much tax consequences can come into play.
Why ETFs are “hot” right now
You will often hear the biggest advantage to ETFs is that they have lower fees than mutual funds. While ETFs do charge lower fees than the average ACTIVELY managed mutual fund, PASSIVELY managed mutual funds charge fees on par with ETFs on average, negating this advantage.
What ETFs do provide over mutual funds is greater control over the tax impacts of the investment. Taxes are not assessed on ETF investments until you sell your shares. This includes any taxes on sales of assets within the fund. Unlike mutual funds, you can delay the entire tax impact until you sell your shares.
The bottom line
While strawberries and blueberries are both berries, they have some distinct differences. You can think of mutual funds and ETFs in the same way – similar but different. Your personal tastes and preferences will determine which one (or combination) will be right for you. Understanding the basic differences is a solid first step in creating your own investment recipe.
[This post originally appeared at MoneyZen.com] For more MoneyZen in your life, follow Manisha on Twitter at @ManishaThakor, on Facebook at /ManishaThakor or sign up to receive Manisha’s MoneyZen blog via email by clicking here. Photo credit Manisha Thakor]