In recent years, more and more investors are selecting Exchange Traded Funds (ETFs) over mutual funds. But what exactly is an ETF, and how do they differ from the traditional mutual fund? Modern Portfolio Theory (invented by Nobel laureate Harry Markowitz) states that in order to minimize risk, investors should hold a portfolio of many uncorrelated (unrelated) stocks, similar to the expression “don’t put all of your eggs in one basket.” The problem with MPT is that the average investor would need a lot of money and time to create such a diversified portfolio. Mutual funds and ETFs solve this limitation by allowing investors to gain immediate diversification by combining their funds together.

What is a Mutual Fund and an Exchange Traded Fund?

A mutual fund is the pooling of money to purchase stocks or bonds for greater diversification and lower risk. Mutual funds have different objectives which allow investors to obtain diversification among many asset classes with minimal investment. For example, a mutual fund’s objective may be to invest in only large U.S. companies, small companies, technology, bonds, or international stocks; there are many categories to choose from. This allows the investor to gain access to the sector they are most interested in. Mutual funds have been around for over 100 years, but only gained popularity in the U.S. during the 1980s and have grown exponentially since, until the introduction of the ETF.

Started in 1993, ETFs are the newest type of investment vehicle, but offer more flexibility than mutual funds. Similar to mutual funds, ETFs are a diversified pool of investments which allows small investors access to a large number of stocks or bonds. For example, an investor can buy an ETF for $100 and gain immediate access to over 500 stocks thereby limiting their risk. While mutual funds and ETFs have similarities such as allowing investors to diversify their assets among numerous sectors of the market, they differ in important ways.

Tax-Efficiency

ETFs are more tax efficient than mutual funds because ETFs do not trigger involuntary capital gains. If you own a mutual fund, then you have probably experienced a year-end capital gains distribution (even if your mutual fund had a negative return for the year) because trades made by the fund sponsor throughout the year flow to its shareholders. Depending on the size of your portfolio, this can create unwanted and unpredictable tax consequences at year-end because those distributions are taxable. ETFs, however, do not have capital gains distributions because ETF sponsors do not transact with their shareholders. ETFs are traded among other investors. Hence, capital gains/losses are controlled by the investor, making them highly tax efficient.

Liquidity and Transparency

Liquidity is how easily a person can convert an investment into cash with minimal cost and tax consequences. ETFs are more liquid than mutual funds because while mutual fund investors can only buy or sell their shares directly from the fund sponsor and only at the end of each day, ETFs can be traded throughout the day just like stocks. Investors can not only actively trade ETFs, but they can also employ the same trading strategies that apply to stocks (limit or stop loss orders, short-sales, etc.). Also, many ETFs have active options markets as long as there is sufficient daily volume in that ETF. Lastly, it’s easier to “look under the hood” of an ETF versus a mutual fund because unlike mutual funds which report quarterly, ETFs report their holdings daily, giving investors up-to-date information.

Cost

Mutual fund companies, regardless of size, incur significant recordkeeping expenses to keep track of all their shareholders. ETFs, however, are low-cost and do not have such expenses because they are traded among investors just like stocks. Unlike some mutual funds, ETFs do not have sales loads or require minimum investments; investors only have to pay a commission to their brokerage firm to trade ETFs; some brokerage firms have a large list of commission fee ETFs making them even cheaper to trade. In addition, popular ETFs are extremely liquid, as millions of shares are traded each day. This allows investors to easily trade their shares with minimal impact on price.

One may conclude that ETFs are better than mutual funds, but that is not necessarily true. Deciding between the two investment vehicles depends on your intentions. Here are some good rules of thumb to determine whether to invest in a mutual fund or an ETF:

• You can buy fractional shares of mutual funds, but can only buy whole shares of ETFs; however, many new online platforms and apps have eliminated this limitation, but there are fees involved.
• Mutual funds are better for dollar cost averaging than an ETF because of the inability to buy fractional shares of ETFs.
• Many mutual fund companies have imposed minimum investment requirements of $500 or more, but with commission-free ETFs, you can start investing with as little as $25.
• Mutual funds are good for investors seeking an active fund manager to invest in a specific sector. For example, an investor may seek a mutual fund manager who has expertise investing in Vietnamese technology stocks or government debt in Africa.
• For faster access to your money, an ETF is more ideal because it is very liquid whereas a mutual fund only trades once a day.

The growth in ETFs has exploded in recent years, reaching $3.4 trillion by year-end 2017 according to Investment Company Institute. While mutual funds still remain the dominant investment vehicles in individual retirement accounts where the bulk of investor assets are held, it is important to determine which investment is right for your unique circumstances.

Ara Oghoorian, CFA, CFP®, CPA is the President & Founder of ACap Asset Management & ACap Accounting Services.

ACap Advisors & Accountants is a “Fee-Only” wealth management and full-service accounting firm headquartered in Los Angeles, CA specializing in helping doctors and healthcare professionals make sound financial decisions.

Contact ACap at info@acapam.com or 818-272-8511.