|Mutual Funds, Index Funds, ETFs – who is the real winner? |
Yankees versus Red Sox…Rebel Alliance versus the Galactic Empire… Maverick versus Iceman… Team Edward or Team Jacob… Each generation has seen and lived through an epic rivalry, but these pale in comparison to the current one raging in the investment world: passive versus active investing.
People are divided, strongly supporting mutual funds, index funds or exchange-traded funds (ETFs), as the financial product of choice. So how is an investor supposed to decipher the meaning behind all the blog posts, decades-long bets, and financial news to choose the right product and approach for them?
First, let’s meet the contenders.
What is a Mutual Fund?
A mutual fund is a collection of shares, bonds or other types of investments. Mutual funds are actively managed by an investment company, for a fee, on behalf of investors. A portfolio manager chooses the investments that the mutual fund will hold, hoping to choose investments that will be strong performers and avoid poor performers. (This is known as an active fund management – more on this in a minute). Different types of mutual funds are available, including money market funds, bond funds, growth or equity funds and balanced funds, among others.
What is an Index Fund?
An index fund is a subset of mutual funds. An index fund closely tracks the performance of a particular benchmark. For example, if the fund is tracking the S&P 500 (i.e. the index that tracks the performance of 500 large-cap companies on the New York Stock Exchange), then it will need to hold the majority, if not all, of these companies. The goal of an index fund is to mimic (or track) the market’s performance. Indexing is a passive form of fund management.
In general, there are two types of index funds: index mutual funds (a lower-cost mutual fund that tracks an index and is not actively managed by a portfolio manager), or ETFs.
What is an ETF?
An ETF is a subset of index funds. Like mutual funds, ETFs bundle together a variety of financial products to help diversify and minimize risk, and do their best to mimic an index or sector. Unlike mutual funds, ETFs are traded on the stock market. ETFs track the performance of an index or a sector instead of a single stock. There are ETFs that allow you to invest in bonds, equities, specific sectors (such as emerging technology), foreign currencies, and more.
So…which one is right for me?
Before choosing a product, it is important to understand how each is structured, and what type of investing strategy it employs.
Enter: active investing versus passive investing.
Before deciding if you are more comfortable with an actively or passively managed fund, here are some points to consider and discuss with your financial advisor:
Are you happier being a passive or an active investor?
Passive Investing - Slow and steady wins the race. Successful passive investors have a buy-and-hold mentality. They keep their eye on the prize and are able to ignore short-term setbacks. This can be hard – investors tend to want to chase past returns and avoid losses at all costs. Successful passive investing limits the amount of buying and selling within a portfolio, even when facing big setbacks.
Active Investing – Show me the money! Successful active investors try to beat the stock market’s average returns. They have a more hands-on approach: picking and choosing what they think will be big winners and taking advantage of short-term price changes. Successful active investors believe they can beat the stock market – they analyze the right time to buy or sell and, if successful, are right more often than wrong.
How comfortable are you with weathering volatility?Volatility exists in every investment portfolio. The market goes up and down in value regardless of which type of fund you purchase or strategy you employ. It just may look a little different depending on your approach.
Because the goal of passively managed funds is to track the market, you are unlikely to see large boosts of returns in the short term (unless the market has a boom). Passive investors believe that, despite ups and downs, the market will trend upwards in the long run. That also means if the market sees a drop in the short term, so will your fund. This will be a challenge for some investors to stay steadfast in the face of setbacks. Since passive funds track an index or sector, you are limited to investments in these areas, no matter what happens in the market.
In an actively managed account, opportunity may exist for larger gains in the short term. In an active investing strategy, the portfolio manager picks stocks with the goal to beat the market. If the portfolio manager is right, the investor may realize high returns. If they are wrong, the investor is open to higher potential losses. This is challenging for some investors too, because we feel the hurt of a loss much more than the pleasure of a gain of the same amount. Portfolio managers aren’t restricted to follow a specific index. They can use techniques like hedging, short sales or put options, or leave stocks or sectors completely when the risk gets too high. An investor must be prepared and comfortable with the potential volatility and risk, and confident in the portfolio manager’s ability to beat the market.
How much does it cost?
In general, a passive investing strategy results in lower fees than an active investing strategy. This may boost returns in the long run. While ETFs are attractive to many investor because of the lower fees (relative to comparable mutual funds), don’t forget about trading costs! When you buy an ETF, you may have to pay trading fees, which could actually make this option more expensive than an actively managed mutual fund. An actively managed fund is more expensive for the investor.
An actively managed fund requires a portfolio manager as well as analysts and other professionals to help manage the fund. The fees and costs associated with transactions, portfolio management, and other administrative costs are paid for by the investor.
Be sure to talk to your advisor about all the fees involved to buy, sell and hold any investment.
If you do not hold your investments in a tax sheltered plan (like an RRSP), the buy-and-hold strategy of passive investing can help avoid capital gains tax for the year.
Active investors can also maximize tax efficiency with an actively managed portfolio using tax management strategies to offset capital gains taxes.
You should consult a tax expert for more information on the tax benefits and disadvantages for each investing strategy.
And the Winner Is…
In this rivalry, there’s no clear winner. After you speak with your financial advisor, you may find a clear winner, or you may find that a combination of the two will work best to meet your needs. Each investor is unique in their financial situation, needs and risk tolerance. Talk to a financial advisor, who can help build a portfolio that’s right for you!
Firms or individuals who are registered (or required to be registered) are known as registrants. While many different titles can be used, it is the category of registration that will tell you what a registrant is allowed to do.
Make sure you’re working with a financial advisor who is registered to offer the products and services you’re interested in. Check Registration The terms ‘advisor’ and ‘financial advisor’ used here generally refer to a financial professional, and do not indicate a category of registration or licence. The registration category and type of licence is more important than a title. Visit fcnb.ca/CheckNow to check now!