Knowing which basket to use is essential when engaging in activities like apple picking or grocery shopping. The same is true when evaluating your investment portfolio.
The most common “baskets” used for investing today are mutual funds and their younger counterpart, exchange-traded funds (ETFs). They have similarities, but often more differences than common investors realize. You have to look at the details to fully understand which basket is best for you.
To date, mutual funds are still the biggest investment option, but the ETF market has continued to grow at a blistering pace. Remember that the primary owners of exchange-traded funds are the mutual fund companies themselves. Why would that be?
A mutual fund company is required to tell you the fund’s top 10 holdings each quarter. Funds often have more than 100 holdings, so transparency is limited. The majority of ETFs are passive in nature, which means that no consistent investment management takes place inside the fund. Since passive ETFs have such limited trading activity, you know what you own from day one of purchase.
Inside a mutual fund, substantial turnover of holdings occurs, especially in a volatile market. This creates costs for the fund manager and can sometimes have undesirable tax consequences. This manifests in the form of phantom gains, whereby you are forced to pay capital gains on positions you never sold.
On the other hand, ETFs offer not only transparency but also efficiency. The number 1 stock symbol on the New York Stock Exchange is SPY. It is the S&P 500 index traded in a single ticker symbol. It is extremely effective for investors and mutual funds.
The big question is, if ETFs are more transparent, cheaper in terms of expenses, and even have tax advantages, why has the investing public stuck with mutual funds? We believe this is due to a multitude of reasons, some of which may be lack of awareness, lack of understanding, or significant barriers to change. For example, most 401(k) plan providers have a strong incentive to keep mutual funds as the only choice on their platforms.
Perhaps you have a joint or individual account in which large capital gains have accrued and you don’t want to pay the taxes that would result from switching to ETFs. Good news: Due to recent market volatility, it may be time to make the switch from mutual funds to ETFs.
Thanks to the arms race of trading costs in 2019, most major investment stores have eliminated or reduced trading costs for the common investor. Couple the reduction in trading costs with the current market volatility, now could be the perfect time to assess your current portfolio and ensure you have the right basket for the job. That said, you will still need to assess your risk tolerance, fees and time horizon when selecting an investment vehicle.
If you have questions about ETFs, contact the Financial Enhancement Group at yourlifeafterwork.com.