Mutual Funds and Exchange Traded Funds [ETFs] have many similarities, however Exchange Traded Funds were developed more recently to offer modern advantages and flexibility, especially to active investors.
The first successfully released ETF was the "SPDR" (S&P 500 Depository Receipt, commonly referred to as the "spider") in 1993. Mutual Funds have much more history dating back to the 1920's, before the Great Depression.
Both of these funds can be incorporated into an investor's portfolio(s), but the majority of individuals tend to choose one rather than both. This guide is going to explain why an ETF, or inverse ETF holds a number of significant advantages over a mutual fund.
What is an ETF?
ETF is an acronym for "Exchange Traded Fund". Simply put, it's an investment instrument that offers diversified exposure in stocks, bonds, currencies, commodities or a combination of these assets. While it can include multiple assets, it is traded like an individual stock setting it apart from a mutual fund.
What is a Mutual Fund?
A mutual fund is also an investment instrument that offers diversified exposure in similar assets. It is comprised of many investors seeking a professional to actively manage part or even all of their portfolio. To get a further understanding, let's look at what differentiates the two types of funds.
Benefits of Exchange Traded Funds
ETFs are Passive
Mutual funds are actively managed in an attempt to outperform the market. This is not something that beginner investors can do consistently without luck involved. Even a large number of veteran investors regularly lose money trying to outperform.
ETFs on the other hand are passive, meaning they track the market's performance instead of trying to beat it. Because it is simply aligning it's value with the assets being represented in the fund, only minor changes are required.
ETFs provide the ability to actively buy & sell the fund in the same day, as many times as you'd like. Unfortunately, Mutual Funds do not offer this flexibility because they are priced only once per day after the markets have closed. Any attempt to open and close a position in a short period of time is heavily frowned upon, infact it can even get you banned from said Mutual Fund.
No Minimum Investment
ETFs reside on an exchange and trade like stocks, so the only minimum investment is the cost of a single share. If you would like to get started with a small amount of capital, this is a great investment option for you.
Naturally, it makes very little sense to purchase one share in an ETF, but it’s possible. Most mutual funds will have minimum requirements; many starting over $1,000 which can discourage a lot of new investors.
Easier to Diversify
The fact there’s no minimum investment with an ETF means you can easily diversify your portfolio. To achieve the same diversification with mutual funds you would need to start out with a larger amount of money. The average income individual would have enough to invest in 1-3 mutual funds only.
ETFs allow you to spread your assets and reduce the overall risk to your portfolio.
Mutual funds lose a lot of their value when you take into account the tax burden. In an attempt to outperform the market, the fund's management often buys and sells assets. Each time these assets are sold for a profit capital gains taxes must be paid. As you can imagine, this could add up quickly the more active the fund is.
ETFs work exactly like stocks, so you only pay tax on the gains you make at the time of sale. As long as there is no sale, taxes are not paid. So if you purchased an ETF and sold it for a profit several years later, you would not pay any capital gains taxes until the actual year the sale took place.
Also like stocks, any losses incurred at the time of sale, can be deducted from your end of year taxable income.
Conclusion – ETFs are Better for the Active Investor
Mutual Funds do come with benefits such as active management for those not wanting to take on this role. However the majority of people will likely find that ETFs offer more control over their investment portfolio(s) with less capital requirement, making them a more attractive option.
Do you own any ETFs or inverse ETFs?