You may have heard about exchange-traded funds (ETFs) as an alternative to investing in mutual funds.
ETFs are becoming more popular investments with Canadians. In fact, ETFs are gaining assets at an annual rate of 28% at the end of 2017, compared to just 10.3% for mutual funds.
But how do you decide which best fits your investment needs? Let’s compare them.
What are mutual funds and ETFs?
Both are pools of investments managed by professional fund managers. They allow you to invest in a wide variety of stocks and bonds so you can diversify your investments.
Mutual funds and ETFs can be used as part of a buy-and-hold investment strategy (investing over a longer term), while ETFs can also be used for almost any investment strategy, including day trading. ETFs trade in real time (like stocks do), while mutual funds can only be bought and sold at the end of the day and switching investments takes two days in addition to the day a fund is bought or sold.
Both are popular investments with Canadians. The Investment Funds Institute of Canada (IFIC) reports that Canadian investors held $1.48 trillion in mutual funds as of Dec. 31, 2017. As of 2015, one-third of Canadian homes held mutual funds.
According to the Canadian ETF Association (CEFTA), as of Dec. 31, 2017, Canadians have invested $145.75 billion in ETFs.
With both mutual funds and ETFs, you can invest in a registered retirement savings plan (RRSP), registered retirement income fund (RRIF), tax-free savings account (TFSA) or registered education savings plan (RESP). Both can also be held in non-registered accounts.
With both, there are two ways to make money. One is from capital gains when you sell the fund for more than you paid for it. The second is with distributions.
Depending on the type of fund you buy, you may get distributions of dividends, interest, capital gains or other income the fund earns on its investments. With a mutual fund, you may choose to receive distributions in cash or have them reinvested in the fund for you. Unless you request the distributions to be paid in cash, the mutual fund will often reinvest the distributions for you.
Unlike many mutual funds, ETFs don’t reinvest your cash distributions in more units or shares. Instead, the cash is held in your account until you say how you want it invested. You may have to pay a sales commission on whatever investment you buy. Some investment firms offer a program to automatically buy more ETF units for you. You likely won’t pay a sales commission on these automatic purchases.
How do the costs of mutual funds and ETFs compare?
If you’re a cost-sensitive investor, you may be interested in the lower annual fees and no investment minimums offered by ETFs. Just remember that if you wish to invest small amounts of money regularly (such as with dollar-cost averaging strategy or pre- authorized contributions), frequent trading commissions can reduce your returns, increasing the cost of your ETF investment.
Compared to ETFs, mutual funds typically come with minimum investment and higher expenses, such as management and operational fees. However, it’s important to remember that with those higher fees, investors get the services of a manager who is much more involved in the funds’ investment selection and management.
In the publication Canadian Business, financial journalist Larry MacDonald notes, “The mutual fund vs. ETF debate often overlooks the fact that the cost of most mutual funds contains the cost of financial advice…so comparing the costs of ETFs to mutual funds is comparing apples to oranges.”
If you can’t decide between mutual funds and ETFs based on their investment cost, consider what kind of investor you are.
Investing in ETFs
If you enjoy the responsibility of managing your investments, then ETFs may be more your style.
Like stocks, ETFs trade all day, meaning the price of an ETF can change minute by minute. Mutual funds are instead priced once daily, at the end of a trading day. This gives you no option other than to buy at the closing price, which is known as the net asset value.
The day trading flexibility of ETFs works for some investors because they can trade anytime the market is open. If you wish to be involved in your trades and have control over buying and selling, maybe you’re cut out to invest in ETFs.
Investing in mutual funds
On the other hand, if you’re the kind of investor who wants less control and a simpler, more hands-off experience, combined with the advice of an advisor, maybe it’s mutual funds you’re after.
They suit people wanting their portfolio to be professionally managed. You can also easily set up automatic investments in fixed amounts towards your mutual funds – so you don’t have to remember to contribute each month.
As well, mutual funds offer other series and structures that aren’t available in ETFs. These can provide you with regular cashflow or invest your money more tax efficiently.