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For as long as there has been a need to save for retirement, mutual funds have been a mainstay for investors, and for good reason. They offer professional management and instant diversification, which is more than most investors can accomplish effectively on their own.
However, with the advent of index funds and exchange-traded funds (ETFs), investors have more to consider in determining whether mutual funds are still a good investment option for their retirement plan.
How Mutual Funds Work
Mutual funds have always played a critical role for investors seeking a balanced and diversified approach to long-term investing. Most investors don’t have the sufficient capital to buy a portfolio of individual stocks and bonds that can provide adequate diversification.
The core concept of mutual funds is the pooling of money from thousands of investors enabling them to invest in dozens or hundreds of securities and spread their risk.
Investors who lack the time, inclination, and expertise to research stocks can rely on a professional portfolio manager to identify, select, and monitor the portfolio’s holdings; all while making the difficult buy and sell decisions along the way.
Since there are thousands of mutual funds from which to choose, investors have the ability to combine mutual funds with varying portfolios and investment objectives to fit their asset allocation strategy.
Because they are actively managed, mutual funds tend to have relatively high management fees. They could also include other expenses, such as sales loads, and embedded costs for trading and research.
The more actively managed a fund is based on portfolio turnover, the higher these expenses can range. High portfolio turnover also results in more taxable activities, which also eat into the fund’s performance.
All of these expenses can total 2 to 3 percent or more annually, which is a high hurdle for fund managers to overcome in trying to outperform an index. Just one half of a percent difference in fund expenses can negatively impact a retirement plan by tens of thousands of dollars over the long term.
How ETFs Work
Like a mutual fund, an ETF is made up of a portfolio of stocks which provide investors with instant diversification. But that is where the similarities end.
Whereas a mutual fund portfolio is actively managed based on a certain investment objective, an ETF portfolio typically remains static, with few changes except when necessary to match any changes in an index weighting. Its investment objective is to simply match the performance of an underlying index, such as the S&P 500.
Because there is little need to make buying and selling decisions, except to maintain the proper weighting of the portfolio, management fees are minimal, averaging less than 0.5 percent annually. Because there isn’t a lot of buying and selling of securities, they are more tax efficient and have minimal trading or research costs.
Why Choose One Over the Other
Investors who want greater control over the timing and price of their investments might prefer ETFs because they are traded like stocks on the stock exchange. ETFs can be traded any time the exchanges are open, and transactions take place at market prices upon execution.
ETFs with greater liquidity can be traded more quickly with market prices that are more closely aligned with the implied value of the ETFs underlying securities. With less liquid ETFs, the market price could vary more widely with less correlation to the actual value of the portfolio.
Mutual fund shares are also liquid, but they only trade once a day after the close of the market. This is usually sufficient for investors who infrequently buy in and out of mutual funds as required by their investment strategy.
Part of an investor’s consideration goes back to their investment strategy which usually dictates whether they buy and hold their investments or trade in and out of the market. Because of their extremely low fees, ETFs would serve long-term investors better from a cost standpoint.
However, mutual funds may be more cost-efficient for systematic investors because of their automatic investment feature. In terms of taxes, ETFs are typically more tax efficient. However, mutual funds also have an advantage with tax-free exchanges.
Author: Jeff Gitlen