Diversification is important in investing, and products like mutual funds and exchange-traded funds (ETFs) are popular, simple ways to incorporate diversification into a portfolio.
ETFs and mutual funds are similar in many ways but there are also important differences, advantages and disadvantages that investors—particularly high net worth investors—should understand.
A mutual fund—sometimes referred to as a collective investment scheme—enables investors to purchase shares of a basket of securities, such as stocks or bonds. Shares of a mutual fund trade under its unique ticker symbol, just as a stock does. A fund’s investment strategy, as stated in its prospectus, determines the mix of securities the fund manager chooses to purchase and hold.
Investing in mutual funds allows you to gain exposure to a large number of companies, which can increase your portfolio’s diversification and exposure to different markets and sectors. This can be especially beneficial for investors who don’t have the capital to purchase such a large group of individual securities.
The percentage of the mutual fund’s assets that each investor owns correlates with the amount the individual has invested. A mutual fund may hold hundreds, even thousands, of stocks, bonds or other securities. At the end of each trading day, the value of all of the fund’s underlying securities is calculated, and the price of one share of the fund, based on the value of its total holdings, is reported. For some types of funds, the share price may fluctuate based on supply and demand.
Some mutual fund managers use an active strategy—where a manager or management team makes decisions on how the fund invests its money. In contrast, “passive” funds, like indexed funds, often mirror a market index and their holdings have very little turnover over time. Many mutual funds are open-ended, meaning an unlimited number of shares can be issued on an ongoing basis based on demand. Mutual funds can also be close-ended, meaning only a specified number of shares are issued when the fund is first offered for sale to the public.
Shares of most open-ended funds are bought and sold at their Net Asset Value (NAV). Closed-ended funds may trade above or below their NAV, based on supply and demand. Both types of funds have tax ramifications, so it may be beneficial to speak with a tax adviser before investing in different fund types.
Exchange Traded Funds (ETFs) are similar to mutual funds in that they also invest in a pool of assets and each shareholder owns a percentage of the entire investment portfolio. While some ETFs are run through an active investment strategy, many ETFs select securities to mirror a specific index. The ETF universe is wide: You can find an ETF to track everything from global equity to gold futures. Unlike mutual funds, ETF shares can be bought or sold throughout the day, and the price can fluctuate above or below the fund’s NAV based on market activity.
Essentially, ETFs make it as easy for you to invest in a fund as it is to purchase shares of stock on a major exchange.
One of the most important differences is that mutual funds may have higher expense ratios than ETFs. Mutual fund fees vary, and the ones that are actively managed generally charge higher fees. Before investing in mutual funds, it’s wise to be aware of any possible tax consequences, as well as the fact that mutual funds offer less trading flexibility than ETFs or individual stocks.
Investors tend to sell in and out of funds too quickly and end up doing the opposite of what would serve them best. You can’t reap the benefit of even high-performing funds if you sell too soon. When the market is high, investors who want in on the action may rush to buy funds; then, when the market dips, they often become fearful and sell out. This is the classic buy-high/sell-low mistake—and the opposite of what many investors are trying to do. Exhibit 1 provides some more insight into the potential ramifications of buying into and selling out of funds too frequently.
So how hard is it to stay invested? DALBAR, a market research firm based in the US, studies this concept in its yearly analysis. Based on the twenty-five years ending in 2018, the average holding period for the average equity fund investor was just 4 years[i]—that’s only part of a full market cycle, which is about half the duration of the average bull market. This inability to stick with their investment plan can inhibit investors from achieving even market-like results, as shown in Exhibit 1.
Exhibit 1: Hypothetical Growth of $1 Million Dollars Invested 25 Years, 31/12/1993 - 31/12/2018
“Quantitative Analysis of Investor Behavior” DALBAR, Inc. www.dalbar.com. FactSet, as of 10/06/2019. Barclays US Aggregate Government Treasury Total Return Index from 31/12/1993 – 31/12/2018. The characteristics of the above study are shown in US Dollars. Currency fluctuations between the dollar and pound may result in higher or lower investment returns, and other noted characteristics.
Mutual funds and ETFs can act as a cost-effective way to diversify holdings. However, fund fee structures also do need to be considered as different funds may charge fees differently. Though some ETFs may have lower fees than mutual funds, you still need to be aware of all management fees and other costs before buying. These fees can add up and holding multiple funds at the same time can prove to be costly and inefficient due to the competing cost of buying and selling the same security.
As the number of mutual funds and ETFs continue to increase, understanding what the underlying assets are and how well the fund fits your investing strategy can become more complex and time-consuming.
Having a customised plan and professional guidance is especially important for high net worth individuals. One of our qualified professionals may be able to provide you with free portfolio evaluation and discuss any current ETF and mutual fund holdings.[ii]
[i] “Quantitative Analysis of Investor Behavior” DALBAR, Inc. www.dalbar.com. FactSet, as of 10/06/2019. Barclays US Aggregate Government Treasury Total Return Index from 31/12/1993 – 31/12/2018. The characteristics of the above study are shown in US Dollars. Currency fluctuations between the dollar and pound may result in higher or lower investment returns, and other noted characteristics.
[ii] For qualified investors with £250,000 or more in investable assets.