On October 15, 2004, Jon Stewart made an infamous appearance on CNN’s Crossfire, a debate show that reduced political arguments to their biased extremes. Stewart was invited to promote his book but instead high jacked the live segment and embarrassed the hosts on their own show calling them “partisan hacks” engaged in “political theater.” The takedown has over 10 million views on YouTube.
Stewart began by innocently asking, “Why do we have to fight?” Of course, things escalated quickly from there, but the question still stands. As a country, we fight about everything—liberals versus conservatives, Yankees versus Red Sox, creamy versus crunchy, and most recently Lauren versus JoJo—so obviously we fight about money, which introduces the debate between mutual funds and ETFs. There is more nuance and detail than a blog post can contain, but here are the (hopefully) objective highlights.
The Quick and Dirty
Mutual funds became available in the 1970s, and their popularity increased over the next 30 years with the inception of IRAs in the 1970s, proliferation of 401(k)s in the 1980s, and the stock market boom of the 1990s. They provided diversification and professional management, both of which were previously unavailable to the average Joe.
Their structure is fairly straight forward: Investors give money to the fund in exchange for shares, and the fund then buys and sells stock based on its investment strategy. Investors purchase and redeem shares from the fund itself based on the daily calculated net asset value (NAV), which is the market value of all the stocks held by the fund.
Exchange Traded Funds (ETFs) debuted in the early 1990s but have only gained popularity within the past 5-10 years. Most ETFs track a particular index, such as the S&P 500, so they provide diversified passive investment.
Their structure is quite different from mutual funds. Instead of beginning with cash to invest, financial institutions start by bundling stock into “creation units” that are then split into shares and sold on the market, just like stocks. You can buy or sell them at any point during the day.
So… Which is better?
It depends on your personal investment philosophy—Are you an active or passive investor? In other words, do you believe that professional investment managers can consistently deliver returns that beat the market, or do you believe that you will be better off paying lower fees and accepting market returns? Active investors should buy mutual funds with a proven investment manager and reasonable fees. Passive investors should buy ETFs from a reputable institution.
But there are some tax considerations as well. Because of their structure, mutual funds are more prone to capital gains distributions, which result from stock sales by the fund. The capital gains from such sales are passed on to the fund investor, but since mutual funds are not traded on an exchange like ETFs, any redemption of mutual fund shares requires the fund to have cash on hand to return invested capital. So if there is a significant exodus of investors, the fund will have to sell off its positions in order to pay for redemptions.
Let’s not fight—mutual funds and ETFs can both provide diversification and have a place in your portfolio. Their utility largely revolves around your investment philosophy and objectives, but the individual fund you buy has more of an impact than which type.
Josh Norris is an Investment Advisory Representative of LeFleur Financial. Josh can be reached at josh@LeFleurFinancial.com.