Today’s investors face what seems like an ever growing variety of investment choices, with new mutual funds and exchange traded funds (ETFs) continuing to arrive. In recent years, actively managed, fixed income exchange-traded funds have appeared, combining the ETF structure with the potential to outperform an index.*
Trying to make sense of these different products doesn’t have to be overwhelming. Here is what to expect and some factors to consider as you weigh your investment objectives.
A brief history of funds and ETFs
For decades, investors have turned to traditional actively managed, open-ended mutual funds for an easy-to-use product to help them meet their financial goals and deliver the potential to outperform a benchmark (often a widely followed index).
In the early 1990s, financial product evolution expanded the set of investment vehicles available to investors with the creation of ETFs. ETFs gave investors intraday pricing and more discretion over the timing of their trades. Like stocks, ETFs give investors the ability to choose their market entry and exit points throughout the day, allowing them to try and take advantage of market developments in real time.
Mutual fund or ETF?
Watch our video series to see a few examples of what to consider when choosing an investment vehicle. Visit the Learning Center.
Then, in 2008, actively managed ETFs came on the scene. In these vehicles, a portfolio manager attempts to outperform an index versus replicating an index’s performance.
From an investor’s perspective, such ETFs offer a way to combine the potential advantages of active management in the fixed income universe with the trading flexibility of exchange-traded products.
Different products, different experiences
As you consider ETFs and open-ended mutual funds, it is important to recognize how the vehicles’ features can influence your experience. Buying and selling, pricing, disclosure, costs, holding period return, and tax implications can all be different (see the table below). For example, unlike with a traditional open-ended mutual fund, shareholder demand can influence an ETF’s market price, which can result in the shares trading at a premium or a discount to the ETF’s actual net asset value (NAV). The flexibility offered by ETFs—continuous pricing and the ability to place limit orders—means the return measurement is largely based on the market price return during the holding period rather than on the ETF's NAV.
|Characteristics for actively and passively managed funds|
|Exchange-traded funds||Open-ended mutual funds|
|Buying and selling||
|Holding period return||
|† ETFs and mutual funds are subject to management fees and other expenses.|
Which vehicle is right for an investor?
Typically, the best way for an investor to choose between investment vehicles is to accurately identify his or her personal investment horizon and objectives. Consider the following types of investors and their varied objectives.
Saving for a long-term goal
Are you saving toward a long-term goal such as buying a house in five to seven years in a brokerage account? Some brokers may offer the option to automatically invest a set amount each month from your paycheck, which may be appealing. You may also be able to set up a regular purchase program for an open-ended mutual fund from a bank account. This automatic feature is generally not available on an ETF. In these account types, with an ETF, you would generally have to manually place buy orders for each trade.
In this example, the availability of automatic investing could make a traditional open-ended mutual fund more appropriate to meet the investor’s goals.
If you prefer to manage your own accounts and want the flexibility to trade during market hours to implement your preferred investment strategies, ETFs can offer the flexibility to meet your needs. Similar to stocks, ETFs can be traded throughout the trading day and on margin. Investors also have the ability to set limit orders and sell short. Most open-ended mutual funds can only be purchased at their closing prices, or NAVs. ETFs offer daily holdings transparency, allowing investors to review holdings and monitor portfolio risk exposures more frequently than with traditional open-ended mutual funds.
In this example, ETFs may satisfy the investor’s need for more trading flexibility and holdings transparency.
Consider investors weighing options for their established retirement portfolio. With a long-term view, they may not want to devote a lot of time to worrying about the intricacies of an active trading strategy and they want to avoid the potential of buying (selling) shares at a premium (discount). Open-ended mutual funds are available with no loads, no commissions, and no transaction fees. Moreover, mutual funds are bought and sold at their NAV, so there are no premiums or discounts. While an ETF also has a daily NAV, shares may trade at a premium or discount on the exchange during the day.2 Investors should evaluate the share price of an ETF relative to its indicative NAV.
In this example, a traditional open-ended mutual fund could be an investor’s preferred option due to its simplicity.
(Fidelity believes that workplace savings plan participants and savers using other tax-advantaged accounts seeking passive market exposure should weigh the features and benefits of index mutual funds and index ETFs carefully. The potential features an investor may experience when holding index ETFs—tax advantage, intraday trading, trading at a premium or a discount to NAV—are either not meaningful to 401(k) investors (tax advantage) or pose opportunities that Fidelity believes are not in line with sound retirement-savings practices: intraday trading and trading at a potential premium/discount to NAV.)
Investors in a high tax bracket
Investors in a high tax bracket may be interested in investments that offer tax efficiency for their taxable assets. In this scenario, if an investor finds that an open-ended index mutual fund and an index ETF are similar relative to his or her investment objectives, the passively-managed ETF, in general, has the potential to be more tax efficient than the index mutual fund. Actively managed fixed-income ETFs, as well as some actively managed equity ETFs also have these same potential tax advantages versus actively-managed mutual funds.3 However, we caution investors against making long-term investment decisions based solely on any potential tax benefits. Investors should evaluate how an investment option fits with their time horizons, financial circumstances and tolerance with market volatility, as well as cost and other features.
In this example, the investor may choose ETFs to take advantage of the potential for a greater degree of tax efficiency.
While mutual funds and ETFs are different, both can offer exposure to a diversified basket of securities and can be good vehicles to help meet investor objectives. What is important is for investors to pick the best choice for their specific investing needs, whether an ETF, an open-ended mutual fund, or a combination of both.
Here are some points to consider when weighing vehicle options:
- Is the ability to execute fund trades at prevailing prices throughout the trading day important? Consider ETFs.
- Is there a preference for trading a fund at NAV without paying a load and avoiding the potential of paying a premium at purchase (discount at sale)? Consider no-load mutual funds.
- Is the flexibility of trading on margin important? Consider ETFs.4
- Is dollar cost averaging part of your investment strategy? Consider the automated savings features of mutual funds.
- Is it important to know a fund’s holdings each day? Consider ETFs.
- Make sure to consider all costs and expenses related to any investment vehicle.
- Do the benefits of both ETFs and mutual funds have the potential to help meet investment goals? Consider building a portfolio incorporating both types of vehicles to gain exposure to different asset classes.
Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917