If you have been reading about investments in my previous posts, you have seen ETF/ Mutual Fund before. These 2 are popular options for many investing newbies and who do not wish to pick stocks. For both, this job will be carried out by a professional stock picker with fees from you. Let’s understand ETF’s and mutual funds in-depth, which will then give you clarity.
What Is A Mutual Fund?
A mutual fund is a collection of investment assets, it can be a basket of stocks, fixed income and other assets. The composition varies from fund to fund. One mutual fund company can have different funds with different objectives. Some mutual funds only have equities, others may only have fixed income. There are multi-asset funds with combinations of different assets.
A mutual fund company will have fund managers who pick assets and manage the fund. They will also have resources to divide the money across the different assets. Mutual funds will have accounting teams to keep track of the accounts. They do have other staffers to do the checks and balances too.
Mutual funds are also pools of money from different individual/institutional investors. Collectively used to invest in assets and the cost of investment is shared by the investors. Depending on the number of shares, and net asset value, the worth of each share is calculated. This is the NAV price of the mutual fund.
Purpose
The purpose of a mutual is to generate alpha for the investors. Meaning, to gain superior returns than the broader markets. This is because of the assumption that fund managers have the skills to identify winners. These managers together with their analysts will perform necessary research to identify opportunities.
You as an investor trust their ability and hand over money to be managed. Sometimes mutual funds may overperform the market and otherwise not. Mutual funds have to report their holdings to investors along with their performance.
Cost Of Investing
To investors like you and me, investing with mutual funds are expensive. This is because fund houses or mutual fund companies charge investors 0.5% – 2.5%. These fees and other commissions will eat into our returns.
This cost is to pay the trading fees incurred from the buy/sell of stocks, salaries and other overheads. It also goes to the profit of the company. Apart from the recurring management fees, there will be a commission/sales charge at the beginning of investing.
Entry Requirements?
Mutual funds used to have a higher barrier for entry in the past. Currently, they are accessible with lower smaller investment sums. They also offer recurring investment plans too. The least investments will depend on the mutual fund company/fund house.
For recurring investments or called SIP (Systematic Investment Schemes), amounts are usually small. These funds are higher for institutional clients.
There is also a KYC process before the purchases, to ensure investor knows the risks involved. In some jurisdictions, these are stricter to protect the investor’s money.
Performance
The performance of a mutual fund depends on the performance of the underlying assets. Also deducting the fees involved. Mutual funds may be tracking a benchmark. In which, it tries to stay above the benchmark. If the companies the fund manager picked up underperforms, this will be reflected in the nav too.
The mutual fund website will provide performance charts for different durations. Past performances are never indications of promise for future performances. There are websites like morning star that can compare mutual funds.
Dividend Handling
When the underlying assets pay dividends/coupons, funds may distribute it to the investors. Whether a fund does this or not can be found on their website. This will depend on the mandates of the mutual funds. There are mutual funds that re-invests the dividends received too.
Re-balance
Mutual funds managers will rebalance their portfolios based on the mandates. Duration of which will be specified in the website or the documentation by the manager. As an investor, you need not know as and when this happens. But, you will see the difference in holdings in the annual reports.
Liquidity
Mutual fund units work on a subscription basis. And they are liquid, this is because the units can be subscribed and redeemed in a shorter period. Depending on the rules set by the fund manager, it can be done in a few days to a week. You may want to read through the specific information outlined in the documents.
Tax Relief
Some mutual funds help you with tax reduction. All mutual funds do not guarantee this. Only some mutual funds have tax relief. These are also dependent on how long the assets in the fund stays in the portfolio too.
What Is An ETF?
ETF Stands for exchange-traded fund. This looks like a mutual fund, but it is traded on the exchange. Unlike mutual funds which are always active, ETF can be either active or passive. This depends on how the ETF is structured. There exists ETF’s run by fund managers. In which they pick up assets based on the objectives of the ETF. Passive ETF’s attempt to track the performance of an index. For example, VOO is the vanguard ETF that tracks the S&P500. TOP 500 companies in the US are part of this ETF. ETFs are structured to have a self-cleaning mechanism. When a stock underperforms, it may replace by another stock.
Purpose
ETF’s are meant to provide a lower-cost alternative to mutual funds and it is also traded in the stock market. Depending on the nature of the ETF, its returns will differ too. If the ETF is actively managed, the fund manager will perform the buy’s and sells depending on the theme. In the recent day’s there are many popular ETF’s that’s managed actively. Ark Invest by Cathy Wood is one of the popular active ETFs that’s focusing on growth stocks.
A low-cost ETF can be an alternative for active fund management. The passive ETF’s that tracks the broad market will return you the returns of the broad market. They let you have exposure to the entire market with lesser capital.
Cost Of Investing
The cost of investing is generally cheaper for ETF’s due to the passive nature of the ETF’s. Since there is no need to identify the winners because you hold the entire market in the basket. Fees of these ETF’s vary from 0.05 – 1.00%. These are lesser than that of mutual funds.
Like mutual funds, these fees will be used for the administration of the ETF and other fees.
Entry Requirements?
Since ETF’s trade in the exchange like stocks, the smaller purchasing quantity depends on the market. In the US, it can be traded in quantities of 1 share. This reduces the barrier of entry, with this 1 share you may have exposure to the total stock market. Depending on the ETF that you choose.
Also, ETF’s can have option contracts too. If you are an options trader, you may take advantage of this derivative product. This is an option that mutual funds do not have.
Performance
The performance of the ETF depends on the way the fund is managed. for active, it will depend on the selected stocks. if the constituents are of high performers, the ETF can return Alpha. If they underperform the broad market, these can generally yield negative returns in the short term.
There can also be a slight difference in returns due to errors. These average error % will also be mentioned in the ETF prospects. There is an ETF category Inverse ETFs. This demands to be a separate blog post and I’ll try to explain the concept in the future. For an introduction, inverse ETF’s are created by shorting the underlying stocks.
Dividend Handling
When the underlying assets pay dividends/coupons, ETF’s will hold them and distribute them too. Whether an ETF does this or not can be found on their website. This will depend on the prospectus of the ETF. Some ETF’s reinvests dividends automatically.
Re-balance
Active ETF managers will do the re-balancing according to their needs. Passive ones will do the cleansing based on the benchmark index. ETF’s will publish their holdings periodically. There are ETF managers who publish the daily trades on websites too.
Liquidity
As these are traded in the exchange, there are no questions on the liquidity. As long as there are buyers and sellers, you also will be able to take part in the process. These are fast like buying and selling common stocks. When trading ETF, it does not need to wait for a few days to get the sale proceeds.
Be sure to pick up an ETF that has good trading volume. Same as stocks, if there are not enough participants, BID/ASK can have a huge spread.
Tax Relief
According to Fidility.com, ETFs have 2 major tax advantages compared to mutual funds. Due to structural differences, mutual funds incur more capital gains taxes than ETFs. And, capital gains tax on an ETF is incurred only upon the sale of the ETF by the investor. Mutual funds pass on capital gains taxes to investors through the life of the investment. In short, ETFs have lower capital gains and they are payable only upon sales of the ETF.
Which is better ETF or Mutual Fund?
Since we have already mentioned the different aspects of both ETF and mutual funds, I let you decide on this. The answer depends on your priorities to the different aspects. So, read through the details before you choose what works for you.
Who performs better?
It also depends on what kind of mutual fund or ETF you choose. Either way, past performances do not mean that it guarantees future performances. It depends on what’s inside the fund or ETF that determines the performance. It’s also worth noting that the ETF’s outperforms Mutual funds over the long run. Read through the different documents available in ETF or mutual funds websites.
Why choose an ETF over a mutual fund?
I started with investing in Mutual funds. But, once I understood details on how to pick stocks, sold the mutual funds. I have picked up some low-cost ETF’s as well as individual company stocks. I considered the fees involved and choose ETF over Mutual funds. One more factor is the delay in valuation.
Are ETFs good for beginners?
Yes, I would say ETF’s are good for beginners. This is because of the diversification offered by ETF’s. As a beginner investor with little experience, you can rely on the broad market returns or use a low-cost ETF. You may choose an active ETF that’s managed by capable managers.
Conclusion
You may consider the points discussed under the different sections and decide. Always remember to perform your due diligence. Do not trust online gurus’ stock predictions or advice. Choose the professional ones.