In my investment advisory practice, the primary tools for implementing portfolio strategies are exchange traded funds and mutual funds. These typically make up sixty to one hundred percent of a portfolio, depending on portfolio size, objective, and any legacy holdings that may need to be kept around for tax efficiency. Portfolios larger than $2,000,000 may benefit from individual stocks, individual bonds, and occasionally direct real estate investments.
“So, what exactly are exchange traded funds and mutual funds?” You might ask. Well, also known as ETF’s, exchange traded funds can be described as a basket of individual securities which are bundled to allow for the convenient purchase and sale of them all together on a stock exchange, under one ticker symbol. This allows for convenient and cost effective diversification in your portfolio by effectively holding hundreds of securities together and trading them as if they were one investment. Mutual funds also bundle securities together for convenience and efficiency, but there are some important differences to understand between mutual funds and ETF’s.
First, ETF’s trade on stock exchanges and can be bought or sold nearly instantly, whereas mutual fund transactions are ordered in advance and executed at the next market close. The difference may seem trivial, but when rebalancing a portfolio or changing strategies, the mechanics matter. For instance, if you needed to sell a mutual fund in order to purchase more shares of an ETF, or an individual security, you would need to wait for the mutual fund transaction to execute at the end of the day before you had the cash available to purchase the ETF when the market opened again (unless you had a margin account with your broker, which gets dicey).
Second, mutual funds are priced differently than ETF’s. This point can be absolutely crucial if you are trading on a day with high volatility (like today, actually). Here’s why: the total underlying value of all the securities within each share of a fund is called the fund’s net asset value, or NAV. That NAV is calculated daily and is based on the price of each security within the fund at market close. That’s why you need to wait for market close for your mutual fund transaction to execute- mutual funds always trade at the next calculated NAV. In contrast, the price you get or pay for an ETF depends on the market value of the fund on the exchange at the time of the sale, which may be higher or lower than the NAV. That’s right, if you sell below NAV, called a discount, it’s possible that you will get less for your shares than you would if you could sell each security within those shares individually (ignoring trading costs). Of course, you could also capitalize on the situation and purchase the same ETF at that discount, but that may not be appropriate for your investment strategy. Bottom line, it’s important to understand whether you are likely to be trading at a discount or a premium when making ETF transactions. This can be rather hard to do, since quick market movements can change the NAV of a fund mid-day, but the NAV is only reported daily. Also, when buying or selling ETF’s that are newer or fill a niche market, it’s possible that the market price reported on an exchange will be much different than the actual price you get for a trade, since there are fewer investors willing to trade the fund. In these cases, it’s a good idea to use a limit order to execute the transaction and prevent nasty surprises.
If you are investing in a taxable account rather than an IRA, it’s important to understand that both mutual funds and ETF’s will make taxable distributions to shareholders based on transactions and dividends that occur within the funds. Simply said, these distributions are taxed as either ordinary income, qualified dividends, short term capital gains, or long term capital gains, depending on their nature and your holding period of the fund. If you are extremely tax sensitive, ETF’s tend to be slightly more efficient by having fewer capital gains distributions, due to their structure.
In recent years, the number of ETF’s and mutual funds available to investors has exploded. This is great for professional investors like me that craft custom portfolios for clients based on their needs. I can choose to focus on expense reduction, social responsibility, fundamentals, sector exposure, tax efficiency, or other factors, in any combination that fits a particular client.