Different types of assets can make up an individual investor’s stock market portfolio, but two of the most common are exchange-traded funds and mutual funds.
Understanding the difference between the two is crucial, and which type fits your portfolio better will depend on your investment goals and timeline, financial experts say.
While an ETF tracks an index or group of assets, a mutual fund is a professionally managed, diversified pool of securities, according to the Mutual Fund Education Alliance and its Mutual Fund Education Center, a resource for investors and advisors.
An ETF’s price fluctuates throughout the day because the shares trade like stocks. Mutual fund shares, on the other hand, are priced once a day after the markets close. Because ETFs have no minimum investment requirements, it is possible to buy a single ETF share.
[See: 10 ETFs to Buy for Aggressive Growth.]
As with any investment, investors shouldn’t purchase blindly. Here are some key steps to take before clicking the “buy” button.
Create an investment plan. You can’t begin investing unless you know how long you plan to hold the investment, what your risk tolerance is and what the ratio of stocks to bonds will be for your portfolio, says Christina Povenmire, a fee-only financial planner and founder of CMP Financial Planning in Columbus, Ohio.
Answering those questions “begins with your age and your investment objectives,” says Kimber Lintz, director of the Mutual Fund Education Center. The younger you are, the more tolerance you’ll have for risk, Lintz says, but “the older you are, the more cautious you should be establishing an investment program.”
For instance, is the ability to liquidate the fund, or cash in some or all of your investment, important to you? If so, ETFs may be more suitable because they often cost less to trade and are more liquid than mutual funds, says Alexander Gillette, who handles business development for DriveWealth.
Determine each fund’s role in the portfolio. You’ll want to make sure the ETF or mutual fund fits your investment strategy, and that the fund’s objective is easy to understand, says certified financial advisor Benjamin Doty of Koss Olinger in Gainesville, Florida. You’ll also want to research the money manager. Does he or she have a good reputation? A quality product will have a “successful track record for five years, ideally 10,” says Daniel Kern, chief investment officer for TFC Financial Management in Boston.
That track record will give you an idea of how much risk and return an ETF or mutual fund is likely to add to your portfolio. The fund’s potential risk and return should be considered in the context of all your other investments, Doty says. “For one-size-fits-all funds, asset allocation and target-date funds are worth exploring.”
Gillette suggests monitoring an ETF’s tracking error, which measures the fund’s returns against the index it tracks. The tracking error should be as low as possible.
“Over the past 50 years, it was typical for investments in the U.S. stock market to double in value approximately every seven years,” Lintz says. “That has not recently been the case, highlighting how important risk and diversification is.”
[See: The Fastest Ways to Lose Money in the Stock Market.]
A variety of apps and online tools can help investors choose suitable funds. For instance, the investing portal Dvdendo assesses an investor’s risk profile and selects a group of ETFs that meets those characteristics. Another app, Stash, offers investors more than 30 ETFs to choose from, including socially responsible ETFs.
Study what the fund invests in. The funds you choose should be different enough so that they “are not overweighting similar stocks,” Lintz says. You won’t be as diversified if several of your funds invest heavily in the same company or sector.
If a fund invests in individual stocks that you don’t recognize or do not feel good about, do some research to make sure you are not exposing yourself to potential downside risk, Gillette says.
Is the fund a long-term or tactical holding? A fund that invests in a broad range of stocks will serve best as a core part of your portfolio while investments in a single country or sector may be “tactical investments that are expected to have shorter holding periods,” Kern says.
If holding for the long term, look at the downside capture ratio, says Andy Yadro, a financial planner with Googins Advisors in Madison, Wisconsin. The downside capture ratio measures how well a fund performs against the broader market, such as the Standard & Poor’s 500 index, the Barclays Capital U.S. Aggregate Bond index and the MSCI EAFE index.
“If the fund has a ratio of less than 100 percent, that means it has historically provided some protection against market downturns. Consistently losing less during downturns can be monumental in predicting superior returns over the long term,” he says.
Pay attention to costs. The costs associated with ETFs and mutual funds include expense ratios, trading spreads, trading fees and tax distributions.
“Trading costs may be more important factors for ETFs that are purchased for tactical purposes, while expense ratios may be more important for ETFs that will be held for many years,” Kern says.
The average ETF has an expense ratio of around 0.5 percent, although funds from Vanguard, Schwab and iShares often offer them cheaper, Gillette says. The average mutual fund expense ratio is closer to 1 percent.
Index funds typically have lower expenses than actively managed funds, says Paul Jacobs, chief investment officer of Palisades Hudson Financial Group in Atlanta.
[See: 8 Investing Tips for New College Grads.]
“Because of this, many index funds have outperformed their actively managed peers over the last one, five and 10 years,” he says. “For many actively managed funds, the hurdle of their high fees is simply too high to outperform over the long term.”
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How to Choose an ETF or Mutual Fund originally appeared on usnews.com
