Six of one, half a dozen of another? It’s easy to mistakenly see mutual funds and ETFs that way – as two slightly different routes to achieving the same investing goals.
Actually, these two investing tools are more different than you might think. While mutual funds have long been a popular way to efficiently invest in multiple stocks or bonds, ETFs have been gaining in popularity since 1993. That was the year the first ETF, the S&P Depository Receipt – now the SPDR S&P 500 ETF (NYSEArca: SPY) – was introduced as a security that would mimic the performance of the S&P 500.
Today, just as you can buy mutual funds covering a broad spectrum of investment sectors, you can buy all sorts of ETFs representing a variety of stock sectors, as well as other asset classes such as bonds, real estate and commodities.
Like mutual funds, ETFs offer a simpler way to diversify your portfolio and invest in a sector that you’re interested in.
So how are the two tools different? Here’s what interested investors need to know about mutual funds vs. ETFs.
Active vs. Passive Management
When you buy an actively managed mutual fund, you are to a large degree paying for the expertise of a fund manager, who will actively oversee the fund and buy and sell shares based on broad economic and fiscal trends, as well as individual company data. With an ETF, on the other hand, you’re basically committed to owning what you pay for up front.
Take the SPDR S&P 500 ETF as an example. If you buy a fund that owns all the S&P 500 stocks, or some representative sample, then that is what you will own for as long as you own the fund, plain and simple. It certainly looks like a diversified blend, but if you enter a broad-based bear market, even your diversified mix will likely run into trouble.
Fund managers will also be challenged to generate returns in a steep bear market, but their job is to respond to market conditions and make the most appropriate investments under the circumstances.
Note that while some ETFs are actively managed, the majority are not.
You pay a price to have your investments managed and will typically pay more for an actively managed mutual fund. Be sure to review the fund’s performance history to see if you’re getting your money’s worth.
Liquidity and Pricing
This is a key difference. Despite the fact that ETF stands for exchange traded fund, it actually trades more like a stock. While mutual fund prices are determined once a day at the end of market trading, ETF prices change throughout the day.
Depending on your own investing style, this can be good or bad. The intraday pricing of ETFs may offer better windows for buying low and selling high, but unless you’re investing with a day trader mentality, this may not work to your advantage.
Also, depending on the focus of the ETF you’re buying, low liquidity may result in large gaps between bid and ask prices, which may make it difficult to take profits at a given time. This is not necessarily a factor if you plan to buy and hold for the long haul, but it could present problems for near-term investors.
While all investments are subject to risk, first-time ETF investors should know about the particular risks associated with inverse and leveraged ETFs.
Inverse ETFs are designed to deliver returns in the opposite direction of the index’s returns, and will in theory gain value in a bear market. Leveraged ETFs promise twice the return of the index. If it rises 5%, you see a 10% gain.
It may look simple and reasonable on paper, but in the same way that these tools can multiply gains, they can also multiply the risk. For example, if you hold a leveraged ETF when the index is growing, you’ll see double the growth. But if the index reverses course, you can see double the losses just as quickly.
There may be some scenarios where sophisticated investors can use these tools to their advantage, but in general, the term, “Do not try this at home,” should apply. While both mutual funds and ETFs can be effective ways to maintain a diverse portfolio, it’s rarely a good idea to be too weighted in any single sector or any single tool. Use either, or both, of these tools as part of a broader portfolio.
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