Many investors find ETFs and Mutual Funds simple and useful investment vehicles.
Exchange Traded Funds (ETFs) and Mutual Funds are investment vehicles that invest in a basket of securities, often based on a guiding philosophy, investment objective, sector or country. Investors are able to purchase shares in these investment vehicles that give them indirect exposure to the securities that the fund owns.
Mutual Funds are further divided into open-end funds and closed-end funds (CEF), of which the latter is more complex. In this piece, we’ll discuss open-end mutual funds.
What Role Do These Funds Play in Diversification?
ETFs and Mutual Funds allow investors to invest in a wide variety of securities and build a varied portfolio that they might otherwise have difficulty acquiring or managing on their own.
For example, if an ETF has a basket of over 100 equally weighted healthcare securities, an investor would be able to gain the benefits of that diversified basket of securities just by buying a share of the ETF. It would be much more difficult for the investor to buy and keep track of all those securities individually.
Furthermore, ETFs and Mutual Funds will have a distribution of different kinds of sectors and securities that allow investors to easily diversify among different asset classes, and sometimes with securities that they might have difficulty accessing as individual investors.
How Are ETFs and Mutual Funds Different?
The first major difference between ETFs and Mutual Funds is their management style. ETFs are almost always passively managed and set to match a specific index or investment style. Mutual Funds can be passively or actively managed. The actively managed mutual funds have a team that makes buying and selling decisions at the stock or bond level in an attempt to outperform a specific benchmark.
The second important difference between the two types of funds is their liquidity. ETFs are traded on an exchange, which means they can be acquired and disposed of any time during trading hours, as well as during pre-market and after-market trading. Mutual Funds, in contrast, can only be bought and sold at one specific time during the day. The Mutual Fund will collect orders throughout the day and then process them all at a set time after the market closes. (see also liquidity risk)
Because ETFs are traded on an exchange, their price is available in real-time for investors. Mutual Funds are only priced at the end of the trading day. This creates some uncertainty as to the exact price at which Mutual Fund shares will be sold but also reduces volatility during the trading day for shares held.
Net Asset Value (NAV)
Mutual Funds are always bought at their NAV, which equates to the total average price per share of all the securities that the fund owns. ETFs, however, can trade at a premium or discount to the actual value of the securities, which makes pricing an important factor to keep track of.
What are the Benefits and Drawbacks as Investment Vehicles?
As an investor, Mutual Funds and ETFs allow you to easily access a large, diversified basket of securities in a simple and straightforward fashion. Furthermore, investors can make different combinations of ETFs and Mutual Funds to build their own investment strategies and portfolios.
There are however several drawbacks and risks to take into account. The first is fees. Mutual Funds and ETFs charge fees for their services, which for some mutual funds can be as high as 1 or 2% annually.
Furthermore, it is important to look carefully at how Mutual Funds and ETFs are structured in terms of the types of risks they carry, how they weight different securities in their portfolio, as well as how strictly they stick to their investment guidelines. For example, 2 utility ETFs can vary greatly in the stocks they own, and 2 utility Mutual Funds can vary even more so in their composition, risk, and style.
Often overlooked, an additional drawback of Mutual Funds over ETFs is tax treatment. ETFs can be more tax efficient when compared to traditional Mutual Funds, as holding an ETF in a taxable account will generate fewer tax liabilities than holding a similarly structured Mutual Fund in the same account.
ETFs and Mutual Funds offer investors an incredible opportunity to broaden their investment opportunities, but they come with significant risks too. It is important to understand the types of risks as well as your risk capacity and risk tolerance when making these decisions.