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Mutual Funds vs. ETFs: Which One Is Right for You?

Investing has become one of the most popular ways to prepare for retirement and to have a nest egg that you get to control, rather than relying on a company pension plan which has traditionally been the way people prepared their retirement income. Today, many companies offer defined-contribution pension plans or promise retirement income, but how well do you trust your employer managing your retirement money? Do you see your company being around to your 65th birthday? Relying on your company pension isn’t the only way to save money for your golden years.

There are also situations where you may not have a company pension. For example, you may be self-employed or don’t have access to a pension plan, so you’ll need to save money on your own.

Your first thought might be to choose to invest your money in the stock market, hoping that it will be worth a lot later on. But stocks can be very unpredictable, and you never know whether taking a risk now will pay off or not.

For this reason, many people choose safer options like mutual funds and ETFs. These are relatively less risky than stocks and also offer good returns. Now the big question is, which investment vehicle is ideal for you? In this article, we will help you decide which option would be better suited for you. Let’s explore ETFs and mutual funds!

What are ETFs?

Exchange-Traded Funds, also known as ETFs, are a bundle of assets, such as stocks or commodities, that can be traded on an exchange at any time during the trading day. Similar to bonds, stocks, and mutual funds, their price can also differ depending from day to day and with demand.

Investing in an ETF, is way to buy large number of individual stocks or bonds in one transaction, i.e. diversification. Think of ETFs as ‘wrappers’… sort of like a soft corn tortilla used to make a taco. Except in this case, the taco is stuffed with stocks or government and corporate bonds. Yum! Pass the guacamole.

ETFs were introduced back in 1993. Since then, they have gained popularity among individual Canadian investors and financial advisors. ETFs are considered mutual fund alternatives because they are cheaper and are seen as more flexible. Since ETFs are traded like stocks, they can be bought or sold on the stock market as well.

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EFT benefits

  1. Good for diversification: One of the biggest benefits of ETFs is that they offer good diversification. Since it includes several various assets in one fund, you aren’t taking unnecessary risks when investing in ETFs. Some investors use ETFs as a replacement for bonds rather than invest directly in individual bonds.
  2. Accessibility: The biggest benefit of ETFs is that you can buy them anytime during the trading day. The price of an ETF can change minute by minute, unlike mutual funds which are priced once at the end of the trading day which limits you because you have to buy the mutual fund at the closing price.
  3. Low fees: Another great benefit of ETFs is that they have low fees. Because there are no fund managers nor advisor, the expenses of ETFs are much lower than those of mutual funds. This way you can get a decent rate of return on your investments while paying very little in fees.
  4. Tax benefits: Any investment that pays you in capital gains or dividends is tax efficient when compared to interest income.
  5. Reinvest dividends: With ETFs, investors can set up dividend reinvestment plans (DRIPs) with their brokerage or on line account which will automatically reinvest dividends.

Downside of ETFs

  1. Lower dividends: If you are looking for a dividend income, be sure to pick a dividend paying ETF.
  2. Less diversification: Some ETFs are limited to large-cap stocks, which means you could be missing out on potential growth opportunities from mid and small-cap companies. (Cap is short for capital, i.e. money)
  3. Can be complex for beginners: Strategies have gotten increasingly diverse and complicated as the ETF market has developed and evolved.

What are mutual funds?

A mutual fund consist of investments in stocks, bonds or other asset classes that are pooled together which is managed by professional money manager on behalf of the fund’s investors (you). In other words, a mutual fund is a basket of assets which may include stocks and / or bonds. You buy one fund thereby you own small parts of many companies.

By pooling your resources together with other investors, you’re able to minimize risks thru diversification and share the cost of a professional money manager (PM). At the same time, it reduces how much money you need to start investing.

Investing in mutual fund is done by purchasing the fund’s units (shares). New units are issued by the fund when more individuals invest. If one investor cashes out his / her units, they cause the sale of  portion of the basket. You are not impacted.
portfolio manager (also known as a fund manager) is in charge of overseeing the investments made by the mutual fund’s investors. They manage the fund on daily basis, making investment decisions based on the fund’s investment goals. This means that it is a ‘hands off’ approach for you, as an investor, since the fund is managed for you by the portfolio manager. Having a portfolio manager who’s sole job is to manage the fund and understand the markets and investments your funds are in maximizes returns and minimize risks. However, it isn’t free. Mutual funds will charge annual fees for fund operating expenses – also known as mutual fund expense ratios (MER) or advisory fees. These fees will typically be between 1% and 1.5% of your investment in the fund per year. More exotic funds, like China or emerging markets will cost more as there is more oversight required. Think of the difference in tracking foreign markets or companies compared with following a Canadian bank stock mutual fund.

What are the benefits of mutual funds?

Mutual funds are one of the well-known investment vehicles and offer several benefits. Here are some of the main ones:

  1. Professional management: A professional investment manager or fund manager will decide where and how to invest your money. They’ll also explain their reasoning behind these decisions, helping you gain a better understanding of your investments.
  2. Diversification: This is the most important characteristic of Mutual funds. They allow investors to buy into different types of investments through one single investment, pooling together their money to minimize risks and costs. Imagine this: you think Europe is going to do well Economically. So, you want to buy European equities. Which is likely more successful? You sit in your office and buy individual company shares OR you ‘hire’ a professional in Europe?
  3. Liquidity: Investors can sell mutual funds at any time since they are publicly traded, making it a great option for both short and long-term investments.
  4. High returns: Mutual funds have historically outperformed other investment types, with an average return of 8-9%, according to several studies.
  5. Easy to invest: Mutual funds offer investors the opportunity to invest their money regardless of how much they have. It is also ideal for beginner investors to start their investment journey.
  6. Safety and transparency: Mutual funds are very transparent and safe investments. They are heavily regulated by the government, thus protecting you from fraud and other types of misbehaviour from fund managers.

Disadvantages of mutual funds

Just like any other investments, mutual funds are also not free from risks. The key disadvantages of mutual funds are:

  1. Fees: Mutual funds charge fees to cover operational costs, management fees, administration fees, marketing fees, etc. These can add up quickly, reducing your profits. They are typically 1% – 1.5% of your investment each year.
  2. Less control: When investing in mutual funds, you’re not in control of the investments made on your behalf – that’s the fund manager’s job. This is the opposite of diversification: if you had bought one company whose stock soared, you’d be rich. But in a fund, likely only 2% of your money is de facto invested in that company.
  3. Tax consequences: Mutual funds are subject to capital gains, dividend & interest income tax. However, many investors use mutual funds in their tax sheltered accounts: RRSP, LIRA, and other tax sheltered investments. You have no tax advantage from capital gains or dividends as 100% of withdrawals are taxable.

Which one is for you?

Both ETFs and mutual funds can be very profitable for your investment portfolio. Both of them have their benefits and disadvantages, which you should consider before making the final decision.

If you are a beginner who just wants to put some money into an investment that won’t take too much time from you, then mutual funds might be right for you. But if you are looking for low fees, ETFs might be the right choice, sans manager.

A few factors that you should consider while deciding between ETFs and mutual funds:

  1. Dividends: Both investments can pay dividends but only in non registered, open, accounts.
  2. Fees: Another thing that you should think about before making the final decision is the expense ratios of both ETFs and mutual funds. Mutual funds have a management team and are normally sold thru advisors, but you pay for that.
  3. Trading: One more thing that can be important for some investors is trading flexibility which is offered by ETFs but not mutual funds.
  4. Risk appetite: ETFs and mutual funds are very different investments with different risks. ETFs can be a better option for those who like taking more risks, while mutual funds might be the right choice for those who prefer safer investments that are managed by an expert fund manager.

Conclusion

As you can tell by now, choosing between mutual funds and ETFs depends on many factors. Do your research and invest in what will help you achieve your retirement goals.

The team at Pension Solutions Canada is here to help you! Allow us to evaluate and review your retirement income sources and assist you with retirement planning. Call us at 1-888-554-6661, or click here to book a virtual Zoom meeting.

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Chat with Certified Financial Planner, Bruce Youngblud. He can advise you on pensions, retirement planning, tax planning and estate planning. Plan to enjoy retirement to the fullest!