For years investors have been looking to diversify their investment portfolios. But how does an investor achieve this goal of diversification? In the past investors would hold the individual stock certificates for the various companies’ they invested in. However, that concept has changed. Today investors are utilizing the internet to research, buy and sell various investments they chose. Investors are still looking for opportunities to diversify their portfolios while limiting the amount of risk they undertake. Holding actually stock certificates and bonds could prove to be more risky than some of the investments that are available to investors today. This is where Mutual Funds and ETFs come into play. Let’s take a look at the advantages and disadvantages of both.
A mutual fund is an investment vehicle made up of capital collected from several investors for the purposes of investing in securities such as stocks, bonds, money market instruments and similar assets. The modern Mutual Fund was created in 1924 by Massachusetts Investors trust in Boston. Mutual funds are typically by money managers, who invest the fund's capital and attempt to produce capital gains and income for the fund's investors. Mutual funds provide a strategic way for investors to diversify their investment assets. Here are a few advantages and disadvantages of owning mutual funds:
Professionally managed: Mutual Funds are professionally managed by individuals who are licensed and typically certified to pick stocks and bonds. They are employed by large money managers like Blackrock or Fidelity. In this capacity they are responsible for picking securities that are tailored to fit the objectives of the underlying mutual fund.
Diversification: Mutual fund managers have the availability to invest in multiple securities across many market sectors. This is increasingly important as it allows for an investor’s capital to be spread across the market, thus limiting the risk ratio in the portfolio.
Liquidity: This is important to some investors as the liquidity and capital availability is among one of the most important benefits for investors. Liquidity gives the investor the opportunity to make money on their investments while having the opportunity to withdraw funds as needed.
No intraday trading: This means that you cannot trade mutual funds as you do stocks. Mutual funds are trading at the end of the trading day at a price called NAV or Net Asset Value. It’s important to understand this as trading in the mutual space can be tedious as you must wait until the end of the day to determine the price of the fund.
Not necessarily tax efficient: Typically in a mutual fund the capital gains are process at year end and distributed to the shareholders of the fund. The investors have little impact or say on how the capital gains are distributed thus, making it slightly complicated to determine tax efficiency.
Costs: Mutual funds always carry some kind of costs. In all cases, costs will decrease your overall rate of return. That is why it is important to understand how costs are baked into mutual funds. Some carry front-end and/or back-end costs, so an investor must understand how this works before investing in the fund.
Introduced to the investment world in 1993, ETFs have become a go to investment for investors. ETFs (Exchange Traded Funds) are marketable securities that simple tracks an index, bonds, commodity or and investment such as an index fund. The price of ETFs changes throughout the day as they are traded like common stock. This means that ETFs typically have higher daily liquidity and subsequently lower fees than mutual funds. ETFs are attractive investments because their performance can be tracked lateral to a stock. With that said let’s look at a few advantages and disadvantages of ETFs.
Diversification: Like a mutual fund, one ETF can be invested in a group of equities, bonds, or an index. In comparison to stock trading an ETF can trade a multiple stocks at a time, making it more efficient than simply purchasing one stock at a time.
Cost: ETFs have lower costs because they are considered to be passively managed. Unlike Mutual funds which are actively managed and there are management fees baked into its expense ratio.
Trade like Stock: ETFs can be purchased just like stock. Sot that means they can be bought on margin, and even sold short. They also trade at prices that are updated throughout the trading day. This is important because investors are able to minimize risk by monitoring the ETFs performance throughout the day.
Intraday Pricing: Although the intraday pricing of an ETF is updated throughout the trading day, this might not be good for long term investors (also called Value investors). ETFs have two prices, a bid and a ask. Investors should be aware of the spread between the price they will pay for shares (ask) and the price a share could be sold for (bid). In addition, it helps to know the intraday value of the fund when you are ready to execute a trade.
Costs: Some ETFs may not track a widely accepted index, which may result in higher costs and higher risk.
As you can see there are several benefits of owning both mutual funds and ETFs. An investor needs to understand their risk tolerance, time horizon and liquidity needs before investing in either of the two. All in all, mutual funds and ETFs are great investments for the right investor, and they both can serve a purpose in an investor’s portfolio.