How to Decide Between an ETF and a Mutual Fund

Investing can be a daunting subject, especially when it comes to deciding which type of fund is the right choice for your portfolio. Exchange-traded funds (ETFs) and mutual funds may appear similar on the surface, but there are important differences between the two that can have an impact on your investments. In this blog post, we’ll discuss the key considerations when choosing between an ETF and a mutual fund.

ETFs and Mutual Funds: A Quick Overview

An exchange-traded fund (ETF) is a collection of securities such as stocks, bonds or commodities that trade on exchanges. ETFs are typically passively managed, meaning that they track an index or benchmark, and do not require a manager. However, some ETFs do have an active component. These typically have higher fees than passively managed ETFs. Mutual funds, on the other hand, are actively managed by an investment professional with the goal of outperforming the market. They can also offer access to specialized strategies that may not be available with ETFs.

When to Use an ETF

ETFs may be the right choice for investors who want to save on costs, diversify their portfolios with a wide range of securities and sectors, and benefit from greater transparency and liquidity. Additionally, ETFs can provide tax advantages over mutual funds – capital gains taxes are lower or not applicable until withdrawal.

Cost Savings: ETFs are typically cheaper than mutual funds due to their lower expense ratios. This makes them the preferred option for investors who place a strong emphasis on cost savings. Additionally, ETFs do not include load fees, which mutual funds may charge.

Greater Diversification: ETFs offer greater diversification compared to mutual funds, as they can track a wide range of securities and sectors. This makes them attractive for investors who want to spread their investments across multiple asset classes.

Transparency & Accessibility: ETFs provide detailed information and real-time pricing data to investors, giving them greater transparency into the underlying investments. Furthermore, ETFs can be bought and sold during market hours, meaning investors have more flexibility when it comes to managing their portfolios.

Tax Advantages: ETFs typically incur lower capital gains taxes than mutual funds, or may even be exempt from them until sold. This makes them attractive for investors who are looking to minimize their tax liability.

Example 1:

John is a 35-year-old investor looking to add funds to his portfolio with the goal of growing assets over the long term. After researching various options, he eventually decides on an ETF that invests in U.S stocks. The ETF offers increased liquidity and lower fees compared to its mutual fund counterpart, which makes it an ideal option for John's long-term investing strategy.

When to Use a Mutual Fund

Mutual funds may be the better option for investors who want professional management of their investments and access to specialized strategies. Additionally, mutual funds provide more flexibility when it comes to dividend reinvestment and cost-effective ways to receive income from your investments.

Professional Management: Mutual funds are actively managed, meaning that an investment professional with the goal of outperforming the market is responsible for making decisions on behalf of investors. This allows investors to benefit from professional management and expertise when crafting their portfolios. Some ETFs also have active management with the goal of beating the market. However, the goal of beating the market is rarely met over longer periods in either product.

Specialized Strategies: While ETFs can offer access to a broad range of investments, mutual funds may be used to pursue more specialized strategies. This can give investors access to certain markets and asset classes that are otherwise difficult to access.

Dividend Reinvestment: Mutual funds offer more flexibility when it comes to reinvesting dividends, which means investors can maintain a constant portfolio value without having to add additional capital. This is a minor benefit as most brokerages allow for dividend reinvestment on ETFs as part of their platform. Mutual funds may have it built into the fund.

Receiving Income: Mutual funds may also offer more cost-effective ways for investors to receive income from their investments. This can be beneficial for investors who are looking to generate a steady income from their portfolios on an ongoing basis. Again, this is a minor benefit as many ETFs also include a dividend-paying component.

Example 2:

Sara is a 50-year-old retiree looking for a steady income with minimal risk. After researching various funds, she decides on a mutual fund that invests in dividend-paying stocks and bonds. The mutual fund offers more flexibility when it comes to distributing dividends, which allows Sara to maintain a constant portfolio value without having to add additional capital.

At Mainstay Capital, we choose to use ETFs over mutual funds whenever possible because of their distinct tax advantages and lower expense ratios. ETFs are often exempt from capital gains taxes until sold, which allows investors to minimize their overall tax burdens while still enjoying the same exposure to various markets as with traditional mutual funds.

Comparing Fees

Let's look at an example of how the fees associated with ETFs and mutual funds can impact an investor's return. Let's say you have a portfolio of $100,000 that can be invested in either ETFs or mutual funds. If you invest using a mutual fund, you might incur a 3% front-end load fee, which would reduce the value of your portfolio to $97,000 immediately. Additionally, over the course of a 10-year period, you might incur 1% management fees and a 0.50% expense ratio each year. At the end of the 10 years, your portfolio may be worth approximately $190,000, netting you a total return of 90%.

Now let's look at the same example using ETFs. As previously mentioned, ETFs do not charge a load fee, so your portfolio would still be valued at $100,000. While you would not have to pay 12b-1 fees each year, you might still incur an expense ratio of around 0.20%. Over the same 10-year period, your portfolio would be worth approximately $222,000, netting you a total return of 122%.

As you can see in this example, the fees associated with mutual funds and ETFs have a significant impact on an investor's return. In this case, investing in the ETF over the mutual fund was worth $32,000 due to the absence of front-end load fees and a decrease in expenses. Knowing this information can help investors make informed decisions when choosing which type of investment is best for their financial situation.

Choosing between an ETF or a mutual fund for your investments will depend on your individual needs as an investor. ETFs have the benefit of cost savings, greater diversification, transparency and liquidity, while mutual funds offer professional management and specialized strategies that may not be available with ETFs. As always, it is important to do your research, speak to a financial advisor if necessary, and understand the risks before investing in any financial product.

Whether you're looking for a long-term investment strategy or trying to minimize your tax liability, Mainstay Capital is here to help. Our experienced financial advisors will work with you to find the best option for your needs and can provide assistance when it comes to selecting investments that meet your goals. Contact us today and let us help you make informed decisions about your investments.