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Insights

Mutual Funds vs. ETFs

Many financial news outlets and pundits highlight the beneficial aspects of investing in an ETF (exchange-traded fund) as opposed to holding individual stocks or even mutual funds. ETFs have many features that make them attractive investment vehicles, however investors should be aware that there are risks unique to ETFs. A review of the advantageous aspects of ETFs reveals that investors can get the same benefits from well chosen mutual funds without the additional risk.

ETFs can be uniquely characterized by the following:

  1. Daily Trading: ETFs trade on an exchange and are subject to price movements caused by supply and demand of the fund.
  2. Taxes: ETFs can be tax efficient due to minimal income or dividend distributions with the notable exception of bond or specialty funds. This allows investors to potentially maximize after vs. pre-tax returns.
  3. Ability to short: Since ETFs trade on an exchange and are equity-like in nature, investors have the ability to short an ETF (i.e. benefit from a drop in price).

However, along with these benefits come with added risk.

The pricing of ETFs is subject to market fluctuations and they trade on exchanges in a similar fashion to equities. As a result, ETFs are subject to liquidity risks that can negatively impact investors and create tracking error between the fund and its underlying holdings. A decrease in market liquidity (i.e. a smaller number of buyers and sellers) can cause a spread to develop between an ETF’s NAV (net asset value) and its actual trading price. In such an environment, an investor might be forced to purchase an ETF at a premium or sell at a discount, which can reduce returns.

In order to avoid these risks, investors can utilize mutual funds to reach their investment goals. Mutual funds are similar to ETFs in that they can offer wide diversification. Wealthstream Advisors prefers mutual funds for most asset classes as opposed to ETFs.

Unlike ETFs, mutual funds are not subject to intra-day market fluctuations. Mutual funds trade and are priced at net asset value when the market closes, which eliminates the liquidity issues inherent with daily trading on an exchange.

Several mutual fund companies specialize in low cost, tax efficient mutual funds that invest in hundreds or even thousands of individual holdings. These funds combine the most valuable features of an ETF with lower trading risk.

The mutual funds in Wealthstream portfolios on average have lower expense ratios and tend to be more tax efficient relative to the rest of the mutual fund universe, and do not expose clients to the volatility of intra-day trading with ETFs. All in all, Wealthstream believes that ETFs can add value to a portfolio, however low cost mutual funds eliminate unnecessary trading risk that can hinder portfolio results.

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