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Mutual funds are a common option for diversifying portfolios. They offer low investment minimums and the option for professional management of funds. More than half of the households in the US own funds, making them one of the most popular options for investors. Mutual funds do have their limits and can be costly in overhead, which lessens the returns so investors looking for other options for their monies may want to consider ETFs.
ETFs, or exchange traded fund, were started in the early 90’s and are becoming a popular resource for both Wall Street investors and the average investor. ETFs track the performance of the bond index or stock are like index funds but with more bells and whistles. ETFs offer the investor broad exposure to the market and provide lower operating costs than mutual funds. Essentially, this investment tool was created to pick up the slack from mutual funds.
How Each Type of Fund Works
Typically, a managed mutual fund will start with a lot of cash and a management team. Investors will place their C-notes into the fund and are issued shares when the investment team outlines what to purchase. If you have a good stock selector, returns can be very good. When a fund is popular, it can bring in lots of money. The more money that is brought in, the more shares will need to be created. This necessitates the need for investment manages to go out and purchase for the fund.
Compared to mutual funds, ETFs work in almost the exact opposite manner. It starts with tracking an index and are produced from stocks instead of initial monies. The major investing institutions already have control of the shares. To initiate an ETF, the managers will take a few million shares from the stack and develop a stack of stocks to be representational of the index. The shares are deposited with a holder and will receive creation units in exchange. A creation unit is a large block of shares of the EFT that are divided into individual shares by the recipients and are then traded on the market. If more investors deposit more shares, additional creation units can be made. In essence, the managers are buying into the fund using equities by trading stocks for creation unites.
Which is Better-ETF’s vs. Mutual Funds?
While there is not a right answer to this question, it can make sense for an amateur investor to tap into the EFT market. The low costs for fund management makes it easier to make small purchases of EFTs regularly. With EFTs you can purchase as little of the shares as you want, even if it is just one. Since they are traded like stocks, you can buy and sell at any time.
With mutual funds, you order the shares you want and purchase them for their net asset value at the end of the day. Most investors in mutual funds use their fund’s automatic reinvestment feature that allows any cash that comes back to be reinvestment into other shares of the fund. This eliminates the need to make decisions about where to put the dividends earned. With ETFs, your money will go into your brokerage account much like a regular stock. If the investor wants to reinvest the monies, another purchase must be made and trading fees will be incurred. Some brokers will allow you to reinvest dividend for no additional charges but it depends on the broker.
As for taxes, mutual funds incur capital gains taxes even if you never sell a single share. With EFTs, there are also capital gains taxes to be paid on sales and dividends you receive. If you EFT funds are in your 401k or IRA, any capital gains taxes will not be incurred until the time of collection. If you have EFT funds in a Roth IRA, everything will be tax free.
Deciding between EFTs and mutual funds is a personal choice. Refer to your financial advisor before making a move to ensure the choice you make is beneficial to your financial situation and portfolio strategy.
Need to open an investing account? Here are review posts on your options as well as links to open an account: