Mutual Funds versus Exchange Traded Funds Which Is Better For You?

Both mutual funds and exchange traded funds (ETF) are sophisticated financial products that require more explanation then I provide here. But if you are investor confused as to the difference and when to use one or the other perhaps this will help.

There is a lot of hype & myth surrounding ETFs versus mutual funds. The most common are:

1. ETFs are free
2. ETFs outperform mutual funds

First, nowhere, in the entire universe of investing is anything free. Sometimes we can get things reasonable but free is not something that trips off the tongue of investment houses, brokerage firms, money managers and the ilk. We, they, us are in the business of staying in business. You cannot stay in business by giving away time or knowledge.

Exchange Traded Funds, now numbering around 1,000, are basic off shoots of index funds. They mimic the performance of specific indices such as the Dow Jones or the S&P 500. There are those ETFs that do invest in country specific or sectors such as technology with defined stocks of that sector or country within their portfolios. For example if you bought a Korean country specific fund you will get only Korean banks, insurance, manufacturing and utilities to provide a complete cross section of the country. You would not expect to find Indian industries to be in the Korean ETF as you would in a world or global open ended mutual fund.

ETFs are like mutual funds in that they have a portfolio comprised of individual stocks and bonds but they trade like stocks. You can buy and sell them at anytime during the trading day. A mutual fund can be bought and sold only at the close of the trading day.

ETFs are bought from a brokerage firm and the broker will charge you a fee to buy and a fee to sell. Depending on the broker and how much or little work he, she or they do will determine the fee the broker charges. You cannot buy an ETF for free.  Again, reasonable comes to mind as being a fee that most brokers would charge a customer.

Many mutual funds you may buy direct from the mutual fund management company with no up-front commission.

ETFs also have an expense fee attached to them and  reflects the cost of managing the fund. This fee is basically the same type of fee that is charged by a mutual fund company. All funds have an expense fee that covers the cost of business.  It is called an expense ratio and covers the fund’s cost of doing business: including trading, investment management, custodial services, taxes, accounting and all bookkeeping.

Some people have said to me they can get rich buying only ETFs. What they omit is telling me which ETF is going to get them to Easy Street since performance of an ETF is not guaranteed and some, like all investments, do lose money and some even lose a lot of money. And some even lose a very lot of money extremely fast.

Most ETFs are index funds of one type or another. In that regard it is up to the client or investment professional or representative to create an allocation of ETFs that will provide:

• Reasonable safety
• Diversification
• Active Management

Most of us can buy an active managed mutual fund that can do all those things for us at a reasonable price. ETFs, like a new boyfriend or girlfriend, needs more than passing attention.

For most clients and investors the majority of their savings should be in plain vanilla mutual funds. One recent example comes to mind – the day in May when the markets experienced a sudden  flash crash of 1,000 points for no explicable reason.  What happened next was that some ETF investors did bail out as soon as the news was heard and took a tremendous loss before the markets readjusted. The mutual fund investor, who still wanted out, had to wait until the close of business to have his or her trade confirmed. The difference in timing saved the fund investor money while the ETF investor lost. (Remember mutual funds can only be bought and sold at the close of business and not during the trading day.)

While this is not a situation that happens every day the ETF investor should have a more sophisticated knowledge of investing.  Depending on the client, their experience, needs and sophistication, I do recommend ETFs to complete a portion of certain investment portfolios. It is the same with individual stocks. There is a time, purpose and situation for every type of investment.

An ETF investor should know the risk, cost and specific purpose of the exchange traded fund prior to buying it. Unlike an actively managed mutual fund some ETFs demand a greater amount of investor vigilance.

Most of the ‘I-Made-A-Million’ in the market myths associated with ETFs came about with the China funds and BRIC ETFs. Yes, a few did do well and may do well in the future. However there are emerging market mutual funds and foreign mutual funds with active management that also have performed well.

If you think you are ready to start adding ETFs to your portfolio you should do the following:

• Read Tom Lydon’s book, ‘ETF Trend Following Playbook’.
• Develop a sensible simple investment strategy.
• Understand ETFs are meant to be traded.
• Build slowly on your success or close the book if you find it is not your cup of tea.

Funds, ETFs and individual stocks and bonds all play a part and if used properly can add value to your portfolio.

If you have questions call Paul at 877 783 7080 or write him at pstanley@westminsterfinancial.com. Share this blog with someone who cares about their money.