If you've held a company-sponsored 401(k) or 403(b), you know that your company gave you a false sense of freedom. You may have thought you were "free" to pick from any one of the handful of mutual funds that they picked for you. However, you also may not have had a lot of options to choose from.
With IRAs opened outside of your company, you have the choice of just about any investment option on the market. With all of this freedom, should you hold ETFs or mutual funds?
Key Takeaways
- Individual retirement accounts—IRAs—let you invest pre-tax or after-tax dollars for accumulating retirement wealth.
- IRAs are flexible and you can invest in a wide range of assets. Until recently, mutual funds have been the primary way to diversify or access different asset classes.
- In the past two decades, exchange-traded funds—ETFs—have overtaken mutual funds for adding index or market segment exposure.
- ETFs are less expensive to own and trade more like stocks throughout the day making them more liquid.
Understanding ETFs
Exchange-traded funds (ETFs) are investment vehicles that combine the features of both stocks and mutual funds. They function as a type of investment fund and are designed to provide investors with a simple and flexible way to gain exposure to a wide range of assets. ETFs are listed and traded on stock exchanges (just like individual stocks) so investors can easily buy and sell them.
One distinguishing feature of ETFs is that they are designed to track the performance of specific market indices, sectors, or asset classes. They do this by holding a diversified basket of assets that closely mirrors the composition of the index they are tracking. Therefore, investors can choose an ETF that closely mirrors their desired specifications; by investing in the ETF, they can simply own one type of fund but hold a diversified portfolio of underlying investments.
The creation and redemption process is fundamental to how ETFs operate. When an ETF is created, an authorized participant delivers a specified portfolio of the underlying assets to the fund in exchange for new ETF shares. This is usually a large institutional investor. This also helps demonstrate the visual of the "basketing" effect of ETFs.
Understanding Mutual Funds
Mutual funds operate similarly by collecting money from multiple investors and using those funds to invest in a diversified portfolio of stocks, bonds, or other securities. These funds are managed by professional portfolio managers or investment teams who make investment decisions on behalf of the investors. Mutual funds may distribute income and capital gains.
Investors purchase shares or units of the mutual fund. Their money is pooled together to invest across a broad range of assets. This diversification helps spread risk, reducing the impact of poor-performing individual investments. There are various types of mutual funds including equity funds, fixed-income funds, money market funds, and hybrid funds (which combine multiple types of funds).
Much like ETFs, mutual funds offer a convenient way for investors to access professional management and diversification, making them suitable for investors with various risk tolerances and investment objectives.
It's important to understand the tax implications and rules of holding investments in a Roth IRA vs. traditional IRA. For example, there is greater flexibility around withdrawing contributions in a Roth IRA compared to a traditional IRA.
Similarities Between ETFs and Mutual Funds
Before we discuss the differences between the two and cover how each factor into IRA considers, let's discuss how ETFs and mutual funds are similar. At their core, both ETFs and mutual funds offer investors diversification. They achieve this by pooling money from multiple investors and using it to invest in a portfolio of various underlying assets, such as stocks, bonds, or other securities.
Both types of funds are managed by professionals. These portfolio managers or investment teams are responsible for making investment decisions on behalf of the fund's investors. As a result, both ETFs and mutual funds have fees and expenses associated with them.
Both ETFs and mutual funds provide liquidity to investors. This liquidity allows investors to access their investments easily, unlike some other investment types with limited trading windows or lack of active marketplaces. For this reason, both types of funds are subject to regulatory oversight to protect the interests of investors. Securities laws and regulations mandate reporting, disclosure, and operational standards for both ETFs and mutual funds.
Key Differences Between ETFs and Mutual Funds
With the similarities in mind, let's dive into the differences. These items below will be the deciding factors in whether or not ETFs or mutual funds make better sense for your IRA.
Method of Trade
ETFs are traded on stock exchanges throughout the trading day, providing investors with intraday trading flexibility, while mutual funds are bought and sold at the end-of-day net asset value (NAV) price. This isn't necessarily an issue for IRA investors either way, as an IRA isn't traditionally used for active trading.
Cost Structure
ETFs typically have lower expense ratios due to passive management, tracking indices, and requiring fewer administrative costs. On the other hand, mutual funds can have higher expense ratios, especially when they are actively managed. Mutual funds may involve more research and hands-on management. When investing for a long period of time, these expenses can make a critical difference in evaluating long-term IRA earning potential.
Tax Efficiency
ETFs are often considered more tax-efficient as their structure minimizes capital gains distributions to investors. Meanwhile, mutual funds can generate capital gains within the portfolio which are distributed to investors, potentially resulting in taxable events. Note that the tax status may be different depending on the IRA you've decided to open.
Investment Amount
ETFs usually have no minimum investment requirements, making them accessible to investors with limited capital, while many mutual funds have minimum investment amounts that may be a barrier to entry for smaller investors. Even though you may be saving for retirement over a long period of time, you may only be able to contribute a little bit each period. If this is the case, you may not quality for mutual fund contributions.
Share Characteristic
Mutual funds are bought and sold at their NAV,which is calculated at the end of the day. ETFs trade just like stocks. You can buy and sell shares at any time during the day at the current price, which changes very rapidly. You can purchase one share of an ETF or millions and even fractional shares. Some brokers may let you purchase fractions of one share and allow you to purchase as many shares as you would like.
Management Style
This item was mentioned above, but it's important so it gets it's own callout here. ETFs are predominantly passively managed. Alternatively, mutual funds can be actively managed. Some investors may have a preference on how the fund is managed and the level of activity surrounding the investment.
Commissions
When you buy and sell a stock or ETF, you have to pay a commission to your broker. For most, this is a flat fee regardless of how many shares you buy or sell. Although it's important to take these fees into account, the more shares of an ETF you purchase, the less the commission matters, since it becomes a smaller percentage of the trade. Increasingly, brokerage firms are adding no-commission ETFs to their line-up, which takes away this concern.
Sales Charges
ETFs generally do not have sales charges such as front-end or back-end loads. However, some mutual funds may impose sales loads, affecting the initial or final investment amount through upfront or redemption fees. Note that there are many no-load mutual fund options, though most ETFs are no-load.
The tax benefits discussed above and below may vary based on the type of IRA you are contributing into, your net income, and your future plans for your IRA.
Which Is Better for IRAs?
ETFs offer several advantages for IRAs. They often have lower expense ratios compared to mutual funds, which can result in higher long-term returns for your retirement savings. Additionally, ETFs are known for their tax efficiency, making them particularly well-suited for tax-conscious investors (opening up a tax-advantaged retirement account like an IRA).
ETFs are structured to lead to fewer capital gains distributions which can also reduce your tax liability when you eventually withdraw funds in retirement, though this may not be a factor depending on your IRA and it's tax implications. Though ETFs are easier to trade during the day, this also isn't really a factor when considering retirement savings in an IRA.
In the end, mutual funds have their place. However, because they are actively managed with often higher fees, their structure is usually less favorable to investors trying to maximize long-term retirement savings growth.
Traditional and Roth IRA Considerations
There are a couple of mutual fund and ETF considerations when picking between your IRA options. Choosing riskier and less expensive investment options for a Roth IRA over a traditional IRA can be a strategic move.
Because Roth IRAs offer tax-free withdrawals in retirement, you tend to want to maximize your earnings in this type of account. This tax-free status makes them an attractive choice for individuals with a long investment horizon and a higher risk tolerance. It also means that ETFs and their lower fees may generate more tax-free wealth over time.
The absence of required minimum distributions (RMDs) in Roth IRAs during the account holder's lifetime adds another layer of flexibility. You can choose riskier options without the pressure of mandatory withdrawals, meaning you can select the riskier investment option as part of your broader portfolio diversification.
One angle to this is that ETFs are more often passively managed. This means a portfolio manager is not actively trying to beat benchmarks or targets. Therefore, you may consider putting your mutual fund in your Roth IRA should you feel more comfortable that the higher fees of that asset be more heavily outweighed by potentially higher income.
How Do I Choose Between Actively Managed and Passively Managed Funds?
The choice depends on your investment goals, risk tolerance, and belief in active or passive strategies. Actively managed funds have fund managers making investment decisions, while passively managed funds track specific benchmarks.
Can I Buy Both Mutual Funds and ETFs in My IRA?
Yes, you can typically invest in both mutual funds and ETFs within the same IRA.
Are There Any Risks Associated with Investing in Mutual Funds and ETFs?
Both types of funds carry investment risks associated with market volatility, asset class risks, and risks tied to their specific holdings. Diversification is essential to mitigate some of these risks. Note that the risk isn't necessarily in the nature of the mutual fund or ETF; the risk is often in the underlying assets held within the financial vehicle.
What Is the Role of a Fund Manager in Mutual Funds?
Fund managers are responsible for making investment decisions on behalf of the mutual fund. They choose the specific assets that the fund will hold in its portfolio. Fund managers conduct in-depth research and analysis of financial markets, individual securities, and economic conditions as part of actively managing the holdings as well.
Can I Switch Between Mutual Funds and ETFs in My Investment Portfolio?
Yes, you can reallocate investments between mutual funds and ETFs in your portfolio based on your evolving financial goals, risk tolerance, and market conditions. Any almost any given time, you can choose to liquidate the holdings of one to increase your position in another.
The Bottom Line
Because most actively managed mutual funds will fail to beat the market over a long period of time, paying the extra fees in loads and expense ratios may not be money well spent. Instead, consider the benefits of passively managed mutual funds or ETFs for your IRA. Both might have a place in your portfolio but because of the ease of buying and selling, and possibly more favorable tax treatment, many IRA investors likely find that ETFs better fit their goals and objectives than mutual funds.
