If you’re looking to simplify your investing strategy, chances are you might be trying to decide between investing in exchange-traded funds (ETFs) or mutual funds. These two investment vehicles share the similar purpose of offering diversified portfolios in the form of a basket of individual securities. In both cases, these baskets are designed to track the performance of a benchmark index, and in many cases they track the same indexes. Also, ETFs and mutual funds both offer diversification and reduce the risks associated with a single stock strategy.
On face value, ETFs and mutual funds look very similar. But before you make a decision about where you want to invest your hard-earned money, it’s critical to understand how these investment vehicles are different. If you don’t, you too could become a victim of the “worst mutual fund ever.”
What Is the ‘Worst Mutual Fund Ever?’
While there are so many facets of investing that are beyond our control, one thing you can take control of is investing fees. That’s a good thing because fees can seriously hinder your rate of return.
ETFs won’t come for free and you will likely pay a commission — although there are now some commission-free ETFs available — but in most cases, commission fees will dull in comparison to the fees that you pay for a mutual fund. The biggest problem is that mutual funds charge a lot of tricky fees that you might not even know about.
Exorbitant fees are exactly how the “worst mutual fund ever” got its name. This fund, the Great-West S&P 500 Index Fund (MXVIX), is not an exotic fund by any means. In fact, it’s a pretty plain vanilla index fund that tracks the S&P 500. But here’s why you should avoid it: It charges 60 basis points, or in other words it has a 0.60 percent expense ratio, reports Barron’s. An ETF counterpart of this fund used to track the S&P 500, iShares Core S&P 500 (IVV), has a 0.07 percent expense ratio, according to Morningstar. That’s a difference of 53 basis points.
To illustrate how that translates over a 30-year period, consider the following:
- Your initial investment into each fund is $100,000.
- You invest for 30 years and don’t add to the account.
If the average rate of return for the S&P 500 is 7 percent gross, your returns are as follows:
- Great-West: Your net return is 6.4 percent and $643,056.
- iShares Core: Your net return is 6.93 percent and $746,426.
For the same investment, your net return on the ETF is over $100,000 more than your net return on the mutual fund. Would you ever just give away $100,000? Probably not, but investing in this fund is just like giving money away. And, this is just one example of how a mutual fund can be a losing proposition.
ETFs Vs. Mutual Funds: 3 Major Differences
Of course, not all mutual funds are like the “worst mutual fund ever.” Still, there are some advantages that ETFs offer but mutual funds don’t. Here are three:
The first major difference between ETFs and mutual funds are the startup costs. Because ETFs trade like stocks, investors can buy small portions of the investment, excluding investors from being held to an investment minimum. This might be particularly beneficial to investors who are just starting out.
On the other hand, mutual funds require an investment minimum, which could range from $1,000 to $10,000.
There are no restrictions regarding how often ETFs can be traded, and trades can be executed throughout the day. A holder of an ETF knows what the price of his or her ETF is every minute of the trading day, allowing for total transparency. This makes ETFs attractive to both passive and active investors.
Mutual funds don’t allow for any intraday trading, resulting in zero transparency throughout the day. A mutual fund’s price, the net asset value (NAV), is calculated only once a day after the stock market closes at 4 p.m.
3. Tax Implications
The next big difference between ETFs and mutual funds are the tax implications. There are no real taxable events within ETFs. Because investors can buy and sell ETFs like stocks, their gains and losses are based directly on their trading.
Mutual funds work much differently. Fund managers are constantly re-balancing the funds by selling securities due to shareholder redemptions or to re-allocate assets. This makes sense, but here’s the catch: The sale of securities within the mutual fund portfolio creates capital gains for all the shareholders. The result? You will incur taxes from the sale of the securities, essentially taking on the tax burden of other shareholders. You probably aren’t happy with your own tax bill — why would you ever want to take on someone else’s?
The clear winner here? ETFs
Keep reading: 10 Stock Market Predictions for 2016
The Bottom Line
Every person has a different set of personal circumstances, and there is no “one size fits all” in the world of investing. If you can’t decide between investing in a mutual fund or ETF, just remember to ask yourself, “Why would I pay more for the exact same thing?” After all, you don’t want to be the victim of the “second-worst” or “third-worst mutual fund ever.”