Passive Income : ETF vs Mutual Fund
There are many ways to invest in order to grow your money passively. One of them is obviously to invest in company shares in order to generate capital gains on shares but also dividends. Obviously, this method requires a lot of time and energy to analyze the thousands of stocks in the world. To overcome this problem, there are ETFs and Mutual funds. Through this article, we will analyze the ETF vs Mutual funds duel and their respective advantages and disadvantages
To better understand what an ETF is, it is important to understand what a Mutual fund is. It is a financial vehicle, managed by a financial organization, which will therefore hold a whole series of shares and bonds or other financial assets. The general idea behind this is to have a group of people who will invest in this fund and buy shares (like stocks). Thus, the investor becomes part-owner of the fund in the same way as if he had bought shares in a company. The difference with shares of a company such as those of Google is mainly the variability of capital which allows investors to move in and out of capital at any time.
This money will be available to the fund which is managed by a fund manager who will be responsible for allocating this collected money to different assets (stocks, bonds, etc.) so as to obtain capital gains and/or income. for investors by respecting the investment objectives and strategies set for this fund.
By investment objectives, we must understand that there are all kinds of funds with very different objectives. For example, some funds are said to be more “defensive” in the sense that they will own a greater proportion of bonds than shares in order to limit the risk of loss of capital (bonds being less risky). Others focus on particular geographic regions or industries, etc. It is even possible to invest in socially responsible funds where the strategy is to allocate funds only in shares of socially responsible companies.
Advantages of Mutual funds
In our ETF vs Mutual funds analysis, we will now see the advantages of Mutual funds. Those are numerous and clearly demonstrate the reasons for the current trend towards this type of investment. Indeed, if you go to the bank to invest your money, there is a good chance that you will be directed to mutual funds. This is for sure an investment that can easily provide you with passive income.
One of the main advantages of mutual funds is their simplicity. Even if the strategies put in place can quickly become complex, these mutual funds are simple for the investor. Whether you are a seasoned investor or just starting out, these funds provide certain benefits (see below) without hassle. All you have to do is allocate some money and everything falls into place without you having to do anything.
The first obvious advantage is the fact that your invested money is placed in the hands of a fund manager who is a professional who will therefore try to optimize the investments as well as possible to obtain the most benefits. A professional manager has the time and knowledge necessary for analyzing stocks and establishing a balanced portfolio. This point will be a major difference in our ETF vs mutual funds analysis.
Doing so, by buying units of a mutual fund, you benefit from investment expertise. The latter will prevent you from having to waste a considerable amount of time looking for and analyzing stocks and bonds in order to balance your portfolio in the best way. All these time-consuming tasks are delegated to an expert in the field.
A second advantage is the diversification that such investment allows. One of the basic rules of investing is not to put all your eggs in one dish. A mutual fund is in a way a group of investors and thus has much greater resources than a single investor.
If an individual would like to diversify, he would have to acquire a significant amount of shares, which represents a significant amount. Via the amount of money invested in the fund, the manager is able to acquire a multitude of financial assets, which ensures optimal diversification. The whole can be accessible to an individual for the price of a share.
Economies of scale
Investing in a mutual fund allows you to benefit from economies of scale. Executed separately, each purchase of a share making up the fund would incur transaction costs. Thus, by purchasing a mutual fund, the individual can avoid all these costs although this does not exempt him from other costs as we will see later. The cost difference is the main point in our ETF vs mutual funds analysis.
Disadvantages of mutual funds
While mutual funds have many advantages, there are also a number of significant disadvantages that every investor should be aware of.
Investment funds, like their constituent financial assets, are subject to a certain variability in income. Indeed, if the equities that make up a fund fall in price, it is obvious that the value of the fund will also be affected. It is therefore indeed a risky investment that can lead to a loss of capital.
As explained, investors can enter and exit the fund with ease. The backlash of such an advantage is that the fund manager must therefore keep a certain amount of money on hand in order to be able to redeem the shares of investors wishing to resell them. This money, kept available for this purpose, is therefore not invested and therefore does not bring in anything.
Although funds avoid a series of costs (transaction fees), there are still others. These costs are mainly used to remunerate the management company (and therefore also the work of the fund manager) but also the financial institutions which are responsible for marketing the products. We therefore find a whole series of costs such as:
- Entrance fee
- Management fees
- Exit fees
These fees are nevertheless relatively high and are mainly charged regardless of the profitability of the fund. You could therefore invest in a fund with negative returns due to bear markets, but you would still be liable for management fees which often amount to 1 – 5% per year.
Often people think that while mutual funds offer good diversification, buying several will allow you to diversify even better. The risk here is to invest in funds which are in fact highly correlated which will have the effect of increasing the portfolio’s exposure to risk rather than eliminating it.
Funds are not fully transparent in the sense that of course they have to report their core values but not all of their portfolios. This therefore does not allow the investor to have a clear idea of the actions where his money is placed.
Unlike company shares, investment funds do not have ratios allowing a comparison between them (such as P / E Ratio, sales growth, etc.).
Exchange Traded Fund (ETF)
At the start of this article, mention was made of the investment funds that we have developed but also of exchange traded funds or ETFs. So, this ETF name is fine, but what does it correspond to?
The term ETF corresponds to Exchange Traded Fund or in French, fund traded on an exchange. It is actually a fund of financial assets, just like an investment fund, whose units are, of course, exchangeable on the stock exchange. The difference with investment funds is that ETFs are often “index funds” in the sense that they will be modeled on a stock market index (CAC 40, S&P 500, etc.). We often speak of “Tracker”. The advantages and disadvantages of this type of financial asset are relatively similar to those of mutual funds with a few exceptions which we will develop below.
Differences with mutual funds
One of the main differences is the absence of a manager whose vocation is to seek out growing stocks that can outperform the market. Here, management is more passive in the sense that the ETF will only hold the shares contained in a particular index and thus replicate the performance of the latter. Thus, the possibility of outperforming the market (or underperforming) does not exist with this type of instrument.
The absence of financial analysts aiming to outperform the market by choosing strategic stocks also enables ETF management costs to be reduced. This is particularly the strong point of this type of instrument which, unlike investment funds, only generates management fees of 0.1 to 0.9% per year.
Unlike mutual funds, mainly marketed by financial organizations, ETFs can be bought directly on the stock market. In this way, they do not impose a minimum subscription and are valued throughout the day where mutual funds are valued only once, at the end of the day.
Conclusion: mutual fund vs ETF?
Although I am not a financial advisor or anything else, from this analysis clearly emerges a benefit for the ETF. Indeed, the latter allows good diversification, just like an investment fund, but entails significantly lower costs. This difference in cost is not negligible, especially since management fees are punctured whether the fund’s performance is positive or negative. Given the current performance of the stock markets, having to pay additional fees of 1 to 5% seems more than absurd.
Moreover, Warren Buffet demonstrated by betting a million dollars that an index linked to the S&P 500 would beat an investment fund, active management of a portfolio cannot beat the market in the long term. This is also one of the advice of the Oracle of Omaha, according to him, it is an excellent way to invest. In his words, “The costs are really big in an investment, if the returns are supposed to be 7-8% and you pay 1% fees, it makes a huge difference to what you get in retirement.” And indeed, simply buying the top 500 US companies through an S&P 500-based ETF gives you a passive approach that protects you from mistakes fund managers can also make.
For my part, I like equity analysis enough to devote time to it, but I still invest a portion of my portfolio in an ETF linked to the S&P 500. This way I benefit from passive management replicating the performance of these 500 large American companies and benefits from very good diversification.
I find it completely revolting the approach of funds in terms of management fees which remain far too high without much capital gain and above all without any assurance of positive profitability. Anyway, as in any area, I will always recommend keeping costs as low as possible (without compromising on quality).
I had also read an analysis on this subject which I would like to share with you:
- An initial investment of 20,000 USD in an ETF following the S&P 500 index which grows for 40 years at an annual rate of 8% with management fees of 0.04%:
- Final investment: 477,811 USD
- Loss in costs: 7,655 USD
- An initial investment of 20,000 USD in an mutual fund actively managed for 40 years at an annual rate of 8.5% with management fees of 1%:
- Final investment: 397,977 USD
- Loss in costs: 194,166 USD
This example perfectly shows that even if the annual rate of the investment fund may seem more interesting, the importance of management fees comes to ruin everything. Management costs clearly matter and should not be overlooked.
I hope this article will have helped you to see more clearly, do not hesitate to send us your opinion on the question or other questions!
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7 February 2021 @ 7:55 PM
[…] of the fund in the same way as if he had bought shares in a company. This explanation is taken from our comparative article between mutual funds and trackers that I invite you to read for more […]