Mutual Funds VS. ETFs
by Tim Guthrie, CFP®– Founder and Chief Investment Officer of Bullseye Investment Management
Mutual Funds
have been around for about 100 years. The oldest mutual fund still in existence today (symbol-MITTX, Name- Massachusetts Investors Trust Class A) was started in 1924. Mutual funds allow anyone to obtain excellent diversification and professional management. Mutual funds invest in financial assets– stocks, bonds, commodities, and real estate securities.
Stocks are ownership in a profit seeking enterprise. Each share of stock represents the same size “slice” of a company. Someone may own 100,000 shares, and someone else may own 10 shares, but each share is equal. Over the long term, stocks have represented the best opportunity for most investors as owning profitable, growing companies over time can result in very good growth of your wealth.
Bonds are debt. When you buy a bond, you are loaning money to a government or company. Bonds typically pay a “fixed,” consistent rate of interest (rent on your money) at regular intervals. At the end of the time for which the bond is offered, the maturity, the bond holder is returned their principal. This is the face value of the bond, usually, $1,000 per bond. Bank CDs work the same way.
Commodities come in several varieties: Energy (oil, natural gas, coal, uranium), agricultural (corn, wheat, rice) metals, (iron ore, tin, aluminum bauxite) and precious metals (gold, silver, platinum). Many commodities are used by all of us every day, but investing in commodities for novices can be fraught with many risks.
Real estate securities are a way to invest in a skyscraper office building or giant mall without having to buy the entire building. Companies in the business of owning and managing commercial real estate can sell shares to the public, just like any other company. This way you can participate in the opportunity of owning a warehouse, strip mall or major apartment complex.
While the various types of financial assets offer opportunities, most investors do not necessarily know which stocks, bonds, commodities, or real estate to own. Additionally, most folks, even prosperous folks, do not have enough resources to be very diversified. This is where mutual funds come in handy. A stock mutual fund will often own 50-200 different stocks spread across many different industries and geographies. This decreases risk as compared to owning stocks in just a few different companies. A professional manager chooses and “manages” (monitors and evaluates) the holdings. A bond mutual fund often owns hundreds or even over one thousand different bonds, with the managers choosing what to own, and when to buy and sell bonds based on interest rates and many other economic conditions.
I hope you can see some of the benefits of mutual funds. You can spread your money easily over many companies, and let professionals take the burden off your shoulders. These factors reduce risk and increase the chances that you will have a profitable experience. Owning mutual funds is like buying clothes already made to your size as compared to sewing your own clothes. I can tell you that I look better letting someone else, an expert, design and manufacture my clothes.
Usually twice a year, the mutual fund sends a report that lists all the securities they own, and if you desire you can read it to learn more about your mutual fund.
Mutual Funds offer more than just diversification and expert management. They can also allow you to diversify across many stocks or bonds while you simultaneously concentrate your assets in preferred sectors such as software, auto manufacturing, or gold mining.
It can get complicated, so many use experts to build and manage a mutual fund portfolio for them.
Data has shown that those who get professional help earn a higher return per year than those who choose to “do it yourself”
(https://www.ramseysolutions.com/retirement/should-you-pay-an-advisor-for-investing-advice).
With mutual funds dating from 100 years ago, we should expect some new technologies to be applied. Enter the ETF (exchange traded fund).
ETFs
serve all the same purposes as mutual funds and have all the benefits of mutual funds and a few additional advantages. ETFs can have all the benefits of mutual funds when it comes to diversification and professional management. ETFs also come in many varieties, just like mutual funds. We use ETFs in the same way we use mutual funds. We build portfolios that own the securities we want clients to own.
How do ETFs differ? The name is a clue, Exchange Traded Fund. Stocks trade on exchanges throughout the day, usually 9:30am to 4pm here in the US. You could buy 100 shares of WMT (Walmart) at 9:32am and sell the same shares later the same day if needed or desired. ETFs are FUNDS (diversified pools of securities, like mutual funds) that can trade throughout the day, just like stocks. You can buy any ETF at any time throughout the trading day.
Mutual funds can only be bought or sold based on the end of the trading day. You must place your mutual fund order (to buy or sell the fund) before 4pm. Then, all the accounting is done for what the portfolio is worth as of closing prices and the share price is determined and your order is then filled to buy or sell the fund.
This may seem like a small difference, and it is, but sometimes it can be important. We can place orders to buy or sell an ETF at a certain price. You cannot do that with a mutual fund. We can place ETFs in a margin account (where we borrow against the value of your securities). Mutual funds cannot be used in a margin account. This too is a small advantage, but we have had clients buy farms with a margin loan against their brokerage account then secure permanent financing a few months later.
ETFs are more “transparent” than mutual funds. Most ETFs must publish daily, all the securities in the portfolio. Daily is clearly better than every 180 days if you (or we) want to check out the fund’s holdings. We use this feature daily at Bullseye.
ETFs have different, and better tax treatment. ETFs can dispose of securities with gains and get cash in return without legally effecting a “sale.” Mutual funds cannot do this. This means that ETFs can often offer years of growth without passing on the capital gains that mutual funds do. This allows you to control, and postpone to some degree, WHEN you pay the taxes on your gains. Mutual funds do not allow this possibility. This is a large advantage. I have seen clients with $100k in a mutual fund that pushed out $28K in capital gains to a client who has not sold the fund, and now they need $7K to pay the capital gains taxes. This will not happen in a properly run ETF. The ETF holder can decide when to sell, and thus when to take capital gains and pay the taxes, even using the proceeds to pay the taxes. This is a significant advantage.
ETFs are cheaper. The average mutual fund has fees of about 1% per year, and the average ETF has fees closer to 0.4%; so, mutual funds cost 250% more than ETFS on average. This too is a significant advantage.
Not only are ETF annual fees cheaper, but ETFs also have another cost advantage. Many mutual funds have sales loads that can be as high as 5.75% and even more mutual funds have 12b-1 fees that usually cost about 0.25% a year. ETFs do not have sales loads. ETFs do not have 12b-1 fees. If you are using ETFs, you are guaranteed NOT to BE PAYING sales loads on the value of your investment. For those hiring professionals to manage their investments, this is a very big deal. Commission based investment reps do not use significant allocations to ETFs because they cannot get paid up front to use them, so they stick to mutual funds and annuities (even higher fees and commissions).
We understand that some esteemed personalities promote using mutual funds and downplay ETFs. The facts are that ETFs are often cheaper, never have sales loads, can be more tax efficient, and still offer all the advantages of mutual funds. ETFs are the “new and improved” mutual fund, and we use them extensively.
This does not mean that we do not use mutual funds. If a mutual fund is a better fit for our desired application, then will be content to use a good mutual fund too.
How to get started with Bullseye
1. Schedule a call with our team
2. Meet with us for your listening session
3. Get your personalized investment strategy
About the Author
Timothy Guthrie CFP®Chief Investment Officer and FounderCincinatti, Ohiotim@bullseyeinv.com513-774-3325
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