Buy-and-hold investors aren’t the only ones who should care about which investments suit a long-term investing horizon best. Fund investors should give some thought to that question, too.
Exchange-traded funds and mutual funds offer similar yet different paths for pursuing a long-term strategy. Over the last decade, more financial advisors have begun favoring ETFs over mutual funds. The Financial Planning Association’s 2017 Trends in Investing Report found that 88 percent of advisors recommend ETFs to their clients, more than double the 40 percent who did so in 2006. Understanding the advantages — and potential disadvantages — of these two types of funds can help you decide where to invest when time is on your side.
Consider how much you invest and how often. Both mutual funds and ETFs are designed to hold a collection of assets, including stocks, bonds and commodities. But there’s one important distinction that sets the two apart: “The primary difference is that ETFs trade throughout the market day and mutual funds trade at the close of day,” says Scott Salaske, founder and CEO of Firstmetric in Troy, Michigan.
[See: 10 ETFs to Buy for High Growth.]
For long-term investors who aren’t investing new cash regularly, mutual funds and ETFs are interchangeable, Salaske says. For younger investors who may be investing more frequently, ETFs can present a challenge with bid-ask spreads and net asset value (NAV). The former refers to the difference between the highest price a buyer is willing to pay for an asset and the lowest price a seller is willing to accept to sell. The NAV is the value of a fund’s assets, minus its liabilities.
Because ETFs trade throughout the day, you never know what the exact NAV of the ETF is at the time of the trade, Salaske says. This can lead to purchasing ETFs above NAV, while with a mutual fund, the purchase price is the NAV. He says that younger investors who are still accumulating wealth may want to stick with mutual funds for simpler and more transparent investing.
How the money is invested, whether as a lump sum or through dollar-cost-averaging, also influences which is better to invest in, mutual funds or ETFs. With mutual funds, which typically have investment minimums, you may need several thousand dollars to buy initial shares, while ETFs, which are sold by the share, usually require less capital. Although fractional shares may be even more affordable for younger investors, investing a lump sum has the potential to produce higher yields over time than dollar-cost averaging, which is investing small equal amounts regularly.
Compare the total costs. Forty-nine percent of advisors cited cost as the most significant advantage of ETFs over mutual funds, followed by greater tax efficiency and trading flexibility. For younger investors with less money to work with, those advantages can enhance returns. “By having a lower cost of doing business and less taxes taken out, the net amount that goes back into the investor’s pocket is more,” says Matthew C. Peck, co-founder of SHP Financial in Plymouth, Massachusetts.
Lower costs can make a significant difference in investing outcomes over time. The average equity mutual fund had an expense ratio of 0.63 percent in 2016, compared to 0.23 percent for the average index equity ETF. If you invest $10,000 each in a mutual fund and an ETF with those expense ratios, as well as an additional $5,000 per year for 30 years while earning a 6 percent annual return, the mutual fund would cost you at least $31,000 more because of the higher expense ratio.
[See: 7 Investment Fees You Might Not Realize You’re Paying.]
Expense ratios, however, aren’t the only investing costs to consider. Because ETFs trade on an exchange, investors also should factor in commissions, although strategic trading could keep those costs from eating returns. “Most brokerage commissions are around $5 per trade, so buying ETFs on the exchange is cost-efficient if done in sufficient size or with a long enough holding period to minimize the initial purchase cost,” says Jay Hatfield, president and co-founder of New York-based InfraCap and portfolio manager of InfraCap MLP ETF (ticker: AMZA) and InfraCap REIT Preferred ETF ( PFFR).
Daniel Kern, chief investment officer at Boston-based TFC Financial Management, says investors should consider the total cost of investment — including expense ratios, transaction costs and trading spreads — over the time frame for holding it. “Trading and trading-related costs may be more significant factors for ETFs that will be traded more frequently, while expense ratios may be the more important cost driver for ETFs or mutual funds that will be held for many years,” he says.
What’s the return potential? Investors also should have an eye on long-term performance, says Brian Rorick, partner and co-founder of Aveo Capital Partners in Greenwood Village, Colorado. He says younger investors who want to build a simple, well-diversified portfolio should consider inexpensive ETFs with indexed exposure to stocks and bonds. “Over the long run, these investments will do a good job of tracking the performance of their underlying index and will not be subject to the potential underperformance that actively managed stock or bond mutual funds can often exhibit,” Rorick says.
Investors who want to expand their diversification horizons, however, may want to consider actively managed mutual funds or actively managed ETFs that invest in areas outside of stocks and bonds. Rorick acknowledges that these investments often have above-average expenses, but investors who are willing to do the research may find options that combine diversification with attractive long-term risk-adjusted returns. This is the measure of how much risk is involved to produce an investment’s return.
[See: These 7 Funds Make You Feel Good About Investing.]
Because this strategy may require a more hands-on approach, make sure you’re willing to invest your time as well as your money. “For investors looking to spend less time monitoring their investments, a diversified portfolio of indexed stock and bond ETFs may be a better fit,” Rorick says.
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ETFs or Mutual Funds: Which Are Better For Long-Term Investors? originally appeared on usnews.com
