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A Mostly Bogus Question: Mutual Funds or ETFs?

November 9, 2018 — Which should you invest in: mutual funds or exchange-traded funds (ETFs)? By summarizing their similarities and differences, I’ll show you why this is a mostly bogus question to begin with.

Both mutual funds and ETFs are “baskets” for holding a batch of underlying securities, such as stocks, bonds and/or REITs. You can use either to invest efficiently in a lot of securities. For example, Vanguard’s Total Stock Market Index Fund holds 3,656 stocks, as does its ETF counterpart. For as little as $3,000 (the fund’s minimum) or $150 (current ETF share price) you can own a fraction of all those stocks in a single fund.

Why does Vanguard offer both? Arguably, the biggest differentiator is that a mutual fund only trades once daily. Whether you buy (or sell) at 9 am or 1 pm, the trade will transact at the same, 4 pm Eastern closing price. In contrast, ETFs trade throughout the day, like a stock such as Apple or IBM.

This difference may appeal to active traders seeking to “game” the market – hoping to improve on that closing price by seeking a better time to jump in or out. But, in largely efficient markets, you’re unlikely to consistently come out ahead for the effort.

There are a few other differences that may actually matter. Long story short, ETFs typically generate fewer taxable capital gains and less dividend income. They’re also often cheaper. That said, the mutual fund industry is more mature by several decades, with a lot more funds available. In the U.S. alone, there are about 27,000 mutual funds, compared to about 2,000 ETFs. Some mutual funds offer better exposure to additional sources of expected return; some of them employ other strategies that are expected to deliver higher, after-cost returns.

Minor variations aside, think of it like this: If you’ve got a patient investment outlook, a plan that reflects your goals and risk tolerances, and a globally diversified portfolio that reflects your patient plan, that’s the cake. After that, choosing between mutual funds or ETFs is the frosting. Besides personal taste, it almost doesn’t matter.

Written by John A. Frisch, CPA,PFS, CFP, PPC, AIF

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