With a huge diversity of investing instruments out there, it’s hard to know exactly where to put your money. Mutual funds are the good old standby and something that we’ve been taught to invest in over the years, especially inside of our 401(k)s and IRAs. In recent years the Exchange-Traded Fund (ETF) has surfaced leaving many asking – should I invest in an ETF? Never fear, we’re here to explain the differences so you can decided if mutual funds, ETFs, or both are right for you and your investing personality.
First, let’s take a look at mutual funds. There are two types of mutual funds to consider: I) actively managed; and II) index mutual funds.
Actively Managed Mutual Fund Advantages
1) Large selection of funds: of all the fund choices available actively managed mutual funds have the widest selection, hands down. There are about 20 times the amount of actively managed funds over index mutual funds.
2) Beat the market: because there is such a great variety of funds available, the fund manager in charge will be critical to the fund’s success. Actively managed funds give you a good shot at beating the market, provided that you’ve chosen your fund wisely.
3) No load no fee availability: a supreme advantage of actively managed funds is that there you can find some of the best no load mutual funds in this class of investments.
Index Mutual Fund Advantages
1) Low management costs: over both actively managed mutual funds and ETFs, index mutual funds have the lowest operating costs, which is important to consider in overall fund profitability for your portfolio.
2) Good for consistent, small investments: for the most part index mutual funds are best for those that practice dollar-cost averaging or other period contributions. This is also because in general these are no-load, no-fee funds which make them perfect for a strategy of regular investing.
ETF Investing – Risky or Safe?
An ETF is basically just an index mutual fund that can be traded as a stock. In way ETFs are a combination of a stock and a mutual fund given their nature and how they are traded.
1) Specific market exposure: with more ETFs popping up every day, you have access to almost any market available in any niche market, industry or type of commodity out there. Types of ETFs range from commodity, metal, oil and financial ETFs – just to name a few. Though there are a tremendous amount of actively managed mutual funds, there may be a market that they don’t cover that an ETF does.
2) Active trading: if you are of the day-trading personality, or want to get into that investing style, ETF are the way to go. You simply cannot actively trade throughout the day with mutual funds – no short sales, stop or limit orders or option trading can be done with mutual funds as with ETFs.
3) Give yourself a tax-advantaged edge: while index mutual funds do have tax benefits, ETFs have the upper-hand in many cases. Certainly they over actively managed mutual funds, which are fairly tax-inefficient.
Final Tips for Comparison
- Check out ETF and mutual fund ratings first for the funds you are comparing.
- Compare the fund history against the benchmark of the market to see performance.
- Watch out for tracking errors between funds; if the data for investing returns is not consistent consider dropping the fund as a selection.
Index mutual funds tend to be for the more conservative investor, while actively managed mutual funds can go from conservative to risky. ETFs have the unique ability to be traded as a stock, and depending on the market can also be quite risky, but potentially profitable, allowing access to niches mutual funds may not cover. Whatever route you choose in your investing, careful comparison and analysis is always the best way to go when choosing investments for your portfolio. Hopefully now you’ll be able to more easily answer the question “what should I invest in?”
Steven Stanich (aka FPT Guy) is owner and author of Financial Planning Tips – where you can find sensible information on personal finance for the average Joe or Jane.