2022 EP0618 | Planning Matters Radio | ETFs vs Mutual Funds

Hi Peter, very good to see you. Today we are breaking down ETFs versus mutual funds. And the reason we're talking about it is that ETFs are really gaining steam here. And it's predicted that global ETF assets will be over $12 trillion by the end of 2023. Look at that.

So let's just start at the tippy top. What's an ETF? What's a mutual fund?

An ETF is an exchange traded fund and it's kind of the newer evolution of mutual funds. The idea is that you get diversification within a single investment. So I sort of liken this to going to the horse races at the track.

You can bet on one horse winning the race. That's kind of like buying an individual stock. Mutual funds and ETFs kind of give the investor the ability to just make the bet that some of these horses are going to finish this race eventually. And it's a much safer bet that's more likely to pay off because of the diversification that you have within that investment.

That makes sense. Well, I know that you really value educating your clients. So the reason we're doing this video is to make sure that people feel empowered to invest in something that they understand.

So we're just going to walk through a series of questions here. But the first question I want to break down between the two is how are they managed? Yeah, so mutual funds have a fund manager. They have a stated objective. They have a prospectus that outlines how that particular mutual fund must be invested.

It's objective, essentially. And the fund manager is in charge of transacting equities inside of the fund to make sure that the fund on whole stays in line with its stated objective. ETFs, on the other hand, don't necessarily have that fund manager nor that expense of the internal management of the equities. And ETF simply tries to buy the entire sector of the market that it is aiming to give the investor exposure to. So there are a number of different types.

But whatever area of the economy you are looking for some exposure to, if you think healthcare or energy or commodities or just a market index in particular is a good place to be invested at the moment, there's an ETF for that. Okay, how are they traded? So mutual funds are traded at the end of the day. So during the course of the day, their value does not change. It is priced at the end of the day. And that is when you can buy or sell or trade. So if some event happens at 11 o'clock in the day, and you say, Hey, I think it's a good time to get out of this mutual fund, you can place that order, but you're not going to sell out actually until the end of the day. Whereas ETFs are active during the course of the day, they can be traded minute to minute. So they are a little bit more tactical in the way that they can be traded, not that you should be attempting to day trade them or sell them minute by minute.

But if that event comes up, they are a little bit more liquid that way. And I just want to show this Venn diagram, which I think is kind of interesting, because it shows the similarities and differences that the two have as we move through these questions again. And I think you hit on this next one, essentially.

So what are the costs? One of them has more of a human element, right? So that might be a little bit more expensive. Exactly.

Yeah. Mutual funds tend to have an average what's called an internal expense ratio of about 1%. And that's one of those hidden costs in the layers of the onion of what you are paying for your money management.

That's often one of those layers that is beneath the surface that people don't really see they aren't really aware of. They may be aware of what they are paying their advisor or some account setup fee. But a lot of times within that account, there are mutual funds that also have internal costs and expenses, those internal expense ratios. I have seen them as low as one half of a percent up to 2% internally. And as opposed to that, ETFs generally are much lower in cost because they don't have that human element and the active buying, selling, trading, exchanging of securities within them as much, they can be much lower cost. And I've seen these range from like 0.25% down to as low as one tenth of 1% or less. So as far as cost efficiency, ETFs I think win there.

That's why they are sort of this newer evolution. And there are some other advantages as well. So the next question is what about tax efficiency?

Peter, I feel like if I had a bingo card with you, that would be my center square, right? Because I know that that is so central to you and your philosophy. When I speak of other advantages, this is the big one. So it does not matter as much within qualified accounts because as we explained on a previous video, inside of an IRA or a 401k, buying, selling, trading and transacting does not generate any taxable event. But for after tax cash that you've gone and invested in a non-qualified investment or brokerage account, this one matters a lot. Mutual funds, without getting too political, are like socialism in investment form.

And I say that in the mantra of socialism is from all according to their ability, to all according to their need. And the way that mutual funds work, if you and I, Aaron, both invested in a mutual fund and then it made or lost money and I wanted my cash out, but you wanted to stay invested. Well, the fact that I wanted my cash out would create an internal transaction that you ultimately would also be responsible for the tax implications of. So what happened in 2008, if we flash back, is that mutual funds across the board actually lost substantial value. Investors probably remember that time. And in non-qualified accounts, a lot of those same people that lost substantial dollar value inside of their mutual funds ended up getting a tax bill for that.

That they owed taxes on when they filed their 2008 returns. And that's because the managers of these funds, when other people went to cash out, they sold the equities that were at the highest gain possible, which created a transaction that was taxable inside of the mutual fund that is passed on to its investors. And so tax efficiency wise, ETFs, again, kind of the newer evolution of being able to diversify within one investment purchase, don't have that tax inefficiency quality. You're only going to have a tax event if you sell at a profit. You're not sharing that responsibility with all of the other investors that are invested in that mutual fund.

Okay. So how do I know then which is right for me? Well, I think that you've got to evaluate that on what you are looking for and how much oversight you want. If you're fairly confident in your own investment or you're trusting an advisor who likes to use ETFs, there's really not a right or wrong universal answer.

Both can be effective. I utilize both for my client portfolios. However, I do like the efficiency aspect of the ETFs and I think that they do offer a little cleaner understanding of what you're actually invested in. I think in either one of these, the waters could be a little murky in understanding what all your mutual fund is actually invested in. That's in that 100 page prospectus that nobody reads and with ETFs also what you are invested in may not be absolutely clear and identifiable right from the gate. But if you say, hey, I would like a healthcare ETF, I would like an energy sector or commodities or a tech sector ETFs or I would just like an ETF that tracks the progress of a specific market index. You can therefore have some clarity on what you are invested in because it owns the entire sector. Well, I'm glad you brought that up because I do want to talk about some ETF themes that are going to be popular in this year and coming up and one of those is mitigating inflation.

Yeah, there are a couple out there for that. TIPS is a famous one, Treasury Inflation Protected Security and this is not a recommendation by any means of any of these but there are certain ETFs that track certain factors of the economy such as inflation. And TIP is one of those. However, you do need to understand getting in that it tracks the change in inflation. So even though we're high in inflation right now, if that number begins to come under control, the Treasury Inflation Protected Security tracking ETF tip could lose value. And these are securities we're talking about.

So that's a statement that can really be said to be across the board. Something else is Bitcoin ETFs and we hear about Bitcoin all the time. Yeah, and that's lost a good bit of value this year as well.

There are all these kind of one-off areas that you could get into. Aerospace, defense, a few others I've named, tech, healthcare, energy, commodities ETFs have performed fantastically this year, but the market is cyclical. And so what has performed very well this year may well be towards the bottom of what's performing well next year. That's why diversification is important. But again, ETFs focus on diversification. So if you've got a few of them in different sectors, not only do you own those different sectors, but you own multiple companies within each sector.

And that's also important because the retail sector could be very healthy, but if JC Penney's or Macy's doesn't do a good job with keeping up with the online nature of how the retail sector works, that specific company may not do very well where the retail sector in general is still doing very, very well. And that's the beauty of the ETFs is that you just invest in all of the companies in that space across the board. Another theme would be ESG ETFs.

We hear about ESG. That is a big one. Environmental, social and governance.

This is one that is for the socially responsible minded. And we're hearing a lot about these because they are really becoming very, very prevalent. And I think that on a surface level, it sounds super attractive, but beneath the surface of what these things are and how they operate, there is a lot of discussion and opposing viewpoints to are these truly a good thing if we are being told or mandated at a very high level, at an institutional level, at a governance level, at a banking or an insurance level, how we must be invested and if these things are really working in the benefit of the average investor or if they are somehow pointing us in a direction that on the surface may seem appealing, but dig beneath the surface and we may actually find we are morally opposed to. I can't say whether or not that is true across the board, but you're going to hear a lot about ESG investing, I think for quite some time to come. And you've got to weigh the benefits and disadvantages and what it really means for your individual specific goals and objectives. And the last thing we wanted to touch on was ETFs in 401ks.

Yeah, that's also becoming a much more commonplace thing, again, because of the cost and the efficiency. I think that more and more employers and plan sponsors are understanding their role, their duty, their responsibility to the employees that are participating in 401k plans. Technically speaking, the employer and the institution is a fiduciary, which means they're supposed to offer you the best options that are in your best interest.

And if they are offering you an option that has a one and a half percent internal expense ratio and there's an option available that is less than one half of one percent that has basically the same objectives and investment results and returns, then it's kind of their duty and responsibility to offer you that less expensive option. There are a lot of other factors inside the 401k that are similar. The ability for the in-service distribution was another one where 401k sort of held people's money captive. And as they neared retirement, they weren't able to escape or choose other options or control their own tax destiny.

More and more companies realized, hey, we don't want to take the responsibility of holding our employees' money captive, so let's give them the option and the out that they can take their money out at 59 and a half and begin to make their own choices with their money and escape some of the responsibility that we technically have for their financial well-being. This was incredibly helpful. And Peter, I know that you are an expert on this because this is also part of your book. Absolutely. Yeah. Understanding your investment options.

Thank you, Erin. I wrote several chapters about the different options that you have. Everything from why do I need a different checking, savings, money market or CD. You know, why are there four different kinds of accounts at banks to stocks, bonds, mutual funds, ETFs, gold, life insurance, annuities? What's the difference between tax deferred versus Roth or tax free versus non qualified? All of these different options.

And to be brutally honest, it's probably the cure for insomnia. But if you want to have an informed conversation and understanding about maybe mutual funds versus ETFs, you turn to those chapters, read five to 10 pages, and you'll be able to get a working knowledge and understanding to have a pretty informed conversation. And by the way, you can go to our website, richonplanning.com, and you can request and download the copy of the book for free. And we'll reach out and be in touch to see if you'd like a physical copy of Understanding Your Investment Options, the most boring book you'll read this year. And I scratched the boring out and I put an important there chalk line written above.

Ladies and gentlemen, I am one of those people, Peter, though, who learned so much more when I can actually sit down with the words in front of me. So I think that is incredibly helpful. Such a great resource for anybody who's interested. And you said richonplanning.com, Richon Planning, phone number and email. 919-300-5886 to give us a call. Email Peter at richonplanning.com. Peter at richonplanning.com.

Same as the website, richonplanning.com. All right, Peter, thank you. Always a pleasure.

Thank you. This has been Planning Matters Radio. The content of this radio show is provided for informational purposes only and is not a solicitation or recommendation of any investment strategy. You are encouraged to seek investment tax or legal advice from an independent professional advisor. Any investments and or investment strategies mentioned involve risk, including the possible loss of principal advisory services offered through Brooke's own capital management. A registered investment adviser fiduciary duty extends solely to investment advisory advice and does not extend to other activities such as insurance or broker dealer services. Advisory clients are charged a quarterly fee for assets under management while insurance products pay a commission, which may result in a conflict of interest regarding compensation.