The increase in interest of exchange traded funds (EFT) has been incredible over the past 20-years. According to the Investment Company Industry, in 1998, there were only 29 EFTs and at the end of 2018, over 1,900 EFTs existed across a range of bonds, stocks, and other securities. At first glance, EFTs seem to have quite a bit in common with mutual funds. Both options give shares across a pool of investments created to reach a specific investment goal. Also, both offer some degree of diversification and manage costs, depending on their objective. Diversification is a critical approach for wealth management but does not eliminate loss risk if prices drop.
Before you become involved in EFTs or mutual funds, Fred Baerenz, President and CEO of AOG Wealth Management advises that you fully understand each option so you are better educated in where your money is going.
Mutual funds work to your benefit by accumulating a pool of money that is then invested per your investing objectives. The result is a collection of bonds, stocks, and securities that are professionally managed. EFTs operate in reverse whereby a wealth management firm creates a new company and moves blocks of shares into it to reach a specific objective. For instance, a company may add a block of shares to track the performance of the S&P 500 and sell shares of this new firm.
Mutual funds are not listed on the stock exchange and do not need a broker-dealer to buy and sell. They can be traded through brokerage firms, financial professionals, and directly through fund companies. On the other hand, EFTs follow traditional stock trading and are sold by broker-dealers on stock exchanges.
Most mutual funds are priced at the closing of the business day. Therefore, no matter when you purchase a share during the day, its price is determined at the close of U.S. stock exchanges. However, the price of an EFT is continuously controlled during the day and fluctuates based on investor security interest, and often trades at a premium.
In addition to structural differences, there are also tax differences between the two. Given that most mutual funds can trade securities, the fund often incurs a capital loss or gain and generates interest income or dividends for shareholders. However, an EFT might only require you to owe taxes on the gain when selling the security. Also, an EFT may distribute a capital gain when the underlying asset is adjusted.
Determining which option is most appropriate for your portfolio requires in-depth knowledge of how these investment types operate. You may benefit from both investment tools depending on your objectives.