Diversification: Mutual Funds vs. Exchange Traded Funds (ETFs)

by Clint Williams

Savvy diversification – a thoughtful mix of stocks and bonds – is much more important to long-term investing than any number of hot stock tips from your cousin’s barber.

Or was it your barber’s cousin?

Fortunately, you can buy stock in all of the America’s 500 largest companies – or a basket of bonds from around the world – while writing a single check to open a mutual fund account. Or by buying a single share of an exchange-traded fund.

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Exchange-traded funds trade on exchange like a stock. Shares can be bought and sold through a brokerage firm at any time during the trading day at the current market price. The net asset value of a mutual fund is determined once a day after the market closes. You can’t buy and sell mutual fund shares during the course of the day.

Mutual funds – sold and managed by companies such as Fidelity and Vanguard – were available before the Baby Boom. Exchange-traded funds – commonly referred to as ETFs – have been around since 1993. Interest in ETFs boomed in the 21st Century. In 2001, ETFs held about $83 billion in assets. In August, that number was $1.465 trillion. While that is a lot of money, the combined assets of the nation’s mutual funds – the investment option of most 401(ks) and IRAs – were $13.857 trillion.

While you can buy actively managed mutual funds – funds in which managers buy and sell in an effort to time the market and beat market averages – most experts says you’re better off simply investing in low-cost index funds. The most popular index is the S&P 500 Index – a basket of the stocks of the biggest 500 companies.

You can buy an S&P 500 index mutual fund and you can buy an S&P 500 ETF. Which is best?

It depends.

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ETFs have a major advantage over mutual funds – you can control when you pay income taxes on your profits. You don’t pay capital gains tax until you sell the ETF – just like selling a share of stock. Mutual funds – even an index fund – will sell stocks throughout the course of the year as stocks join and drop out of the S&P 500, for example. You may have to pay taxes on income you earned from those trades, even though you don’t cash in the mutual fund.

ETFs, for that reason, might be best for investments held outside of a tax-sheltered retirement account.

ETFs also enjoy a slight cost advantage – but not so much that you would really notice.

The expense ratio for Vanguard 500 Index Fund Investor shares, for example, is 0.17 percent. The expense ratio for a Vanguard 500 Index ETFs is 0.05 percent.

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Like a stock, you may have to pay a brokerage commission every time you buy or sell an ETF. But many companies now offer commission-free ETFs. It pays to shop, especially if you’re getting a plain-vanilla index.

Mutual funds often have a minimum initial investment. The Vanguard 500 Index requires a $3,000 minimum investment, for example. You can buy a single share of an ETF.