ETFs and Mutual Funds in Asset Allocation
Building a properly allocated portfolio requires the right tools. The first step is to understand the tools of the trade in asset allocation. Professional investment managers often use diversified pools of securities as one of these tools. While there are different kinds of pooled investments, the most popular are mutual funds and ETFs.
Funds aren’t an asset in themselves; they are vehicles that help you invest in various asset classes. Traditional mutual funds are a collection of securities that are actively managed by an investment manager and his team. They often compare themselves with investment indexes of similar asset classes. Mutual funds have evolved over time, and now some invest in a multitude of assets, some buy other mutual funds, and others simply track an investment index. Mutual funds are typically bought for the benefits of diversification, professional management, and low capital outlay. Many kinds of mutual funds can be expensive to own and cumbersome to sell.
Here are some of the fees mutual funds can charge:
- Management Fees – (normally 0.5%-2.0%) this is how mutual fund companies pay their fund investment managers and staffs.
- 12b-1 Distribution Fees – (0.25% and 1.0%) for marketing to new prospects.
- Administrative Fees – (0.20% – 0.40%) to keep the lights on at the office, paper in the copier, etc.
- Sales Loads – (3.0% – 5.75%) Also known as sales commissions, they are used to pay the sales force who sell the funds.
- Exchange Fees – Additional fees you can incur if you decide a mutual fund no longer matches your investment objectives.
If you buy a mutual fund with a sales load, your investment has to dig itself out of a hole before you can make a penny. That sort of expense is a big drain on your rate of return. Ensure that you evaluate the cost against the value you’ll be receiving when considering a purchase of fund. You can also purchase mutual funds that have no sales charge (load).
An alternative that has been making tremendous strides to mutual funds in the last decade are ETFs. ETFs, short for Exchange Traded Funds, are collections of stocks, bonds, or other assets. They can track a number of different underlying indexes such as the S&P 500. The increasing popularity of ETFs has provided a large menu to choose from. Whatever kind of investment pool you’re looking for, there’s a good chance at least one ETF tracks it.
ETFs are similar to mutual funds in being pooled investments, but have some enormous advantages. Often, the expenses are fractional in comparison to funds, so you don’t have to waste your hard-earned savings on fees every year. The average ETF charges 0.1% – 0.65% annually. This can mean enormous savings over time.
An added benefit is that ETFs provide up-to-the minute pricing while the market is open. You don’t have to wait for end of day pricing, common with most mutual funds. You can buy and sell an ETF knowing the price you’ll pay. ETFs also tend to be more tax-efficient. The passive management of index investing coupled with the lack of pass-through taxes, inherent in most active mutual funds, can reduce your tax headaches.
ETFs still have their challenges. Light trading volume or shallow markets can affect the pricing of some ETFs. In addition, transaction costs can add up if you’re a high frequency trader, although there are ways to reduce these expenses. Some other features such as automatic dividend and capital gain reinvestment that are available in funds, are not generally possible in ETFs.
Pooled investments are an important tool for a majority of investors. The uniqueness and benefits of mutual funds and ETFs are stark compared to individual securities. If you’re constructing a portfolio and you want to buy a diversified block of assets, mutual funds and ETFs are great options. The benefits they provide can be paramount to a successful portfolio.