By Angela Dorsey
In the world of investing, there are many options at our fingertips, but two popular choices that often come into the spotlight are exchange-traded funds (ETFs) and mutual funds. Both investment vehicles come with their own set of strengths and weaknesses and have unique characteristics that set them apart.
ETFs offer flexibility and low costs, while mutual funds provide active management and a long history of success. But how do you know which one to choose? Let’s explore the key differences between ETFs and mutual funds, and help you make an informed decision to set your portfolio up for the highest success.
What Are Mutual Funds?
Mutual funds are a popular investment vehicle that pool money from multiple investors to invest in a diversified portfolio of stocks, bonds, or other assets. They are managed by professional fund managers who make investment decisions on behalf of the investors.
When you invest in a mutual fund, you’re essentially buying shares of the fund, and the value of your investment is determined by the performance of the underlying securities held by the fund. Mutual funds trade only once per day after the markets close at 1:00 p.m. Pacific Time, which means you automatically get the closing price at the end of the day.
One of the advantages of mutual funds is their accessibility and ease of use. They can be purchased through various investment platforms, such as brokerage accounts or retirement plans, and typically have low minimum investment requirements. Also, because mutual funds offer diversification by investing in a wide range of options, this helps spread risk and reduce the impact of any single investment’s performance on your overall portfolio.
How Does an ETF Compare?
An ETF (exchange-traded fund) is a collection of hundreds or thousands of stocks or bonds, managed by professionals, that trades on major stock exchanges, like the New York Stock Exchange, Nasdaq, and Chicago Board Options Exchange.
Unlike mutual funds, ETFs can be bought and sold throughout the trading day at market prices, which allows investors the flexibility to control the price by entering or exiting at any time. ETFs are passively managed and work to copy the performance of the underlying index or asset class they are tracking. This works through the use of a portfolio that mirrors the holdings and weightings of the index, allowing investors to gain broad market exposure in a single trade.
ETFs have gained popularity due to their low expense ratios compared to many mutual funds. They also provide transparency, as their holdings are disclosed daily, allowing investors to see exactly what they own. The transparency and liquidity of ETFs make it a convenient and efficient investment option for people looking for broad market exposure or targeted sector investments.
How Taxes Factor In
When it comes to taxes, there are a few key points to consider with ETFs and mutual funds. Generally speaking, holding an ETF in a taxable account will generate less tax liabilities than if you held a similarly structured mutual fund in the same account.
From the perspective of the IRS, the tax treatment of ETFs and mutual funds are the same. Both are subject to capital gains tax and taxation of dividend income. However, ETFs are structured in such a way where taxes are minimized for the holder of the ETF, leaving the tax bill less than what the investor would have paid with a similarly structured mutual fund.
Remember that tax efficiency is only an issue in taxable accounts and not retirement accounts like IRAs and 401(k)s. And while most people stick with mutual funds, if you find yourself in a higher tax bracket and consider yourself more tax-sensitive regarding your non-retirement accounts, you may want to consider ETFs.
One word of caution: just because you can trade ETFs throughout the day doesn’t mean you should do so! It’s important to always maintain a long-term buy-and-hold perspective. If you think that investing in ETFs will tempt you to trade more often, our recommendation would be to stick with mutual funds.
The Bottom Line
Both ETFs and mutual funds have their advantages and considerations, but the bottom line is that both are good options. Understanding the differences between them, such as trading flexibility, costs, management styles, and tax implications, is crucial in determining which option aligns better with your investment goals.
At Dorsey Wealth Management, we work with clients to help them understand the nuances and complexities of different investment options. By diving deeper into the details, we can help you make informed decisions to construct a well-balanced investment portfolio that suits your unique goals. If you’re ready to expand your financial confidence, reach out to us at (310) 370-7776 or email@example.com.