When building a portfolio, who is the winner?
Investing in the securities market has been a popular means of wealth generation over time. With the plethora of investment products available, choosing one that aligns with one’s investment goals and risk tolerance can seem a daunting task. Mutual funds, exchange-traded funds (ETFs) and stocks are three common options, each possessing unique characteristics. Let’s contrast these three investment vehicles to provide an understanding of their differences.
Mutual funds are professionally-managed investment portfolios that aggregate capital from multiple investors to purchase securities including stocks, bonds or other assets. Their primary advantage is ease of diversification, offering broad exposure to multiple asset classes with a single investment. Additionally, mutual funds are managed by fund managers, an advantage for investors seeking to delegate decision-making. When it comes to taxes, mutual funds are usually considered the least efficient since they do have to pay out annual dividends in order to keep their mutual fund designation.
Exchange-Traded Funds (ETFs) offer similar benefits as mutual funds in terms of diversification and access to multiple asset classes. However, ETFs are listed and traded on stock exchanges, offering the flexibility of real-time trading, similar to individual stocks. ETFs also tend to have lower fees and more tax-efficient characteristics compared to mutual funds. Over the last few years, the number of ETFs has grown, giving investors more opportunities to enter niche indexes at significantly lower prices than before. While ETFs are considered passive investments and offer no money management, they allow investors to add various indexes without paying to have a portfolio manager pick various stocks.
Stocks represent ownership in a company and expose investors to the growth and success of the enterprise. These investments can be more volatile and carry higher risk than mutual funds or ETFs, as the performance of a single company is inherently less predictable. Nonetheless, with due diligence and careful analysis, individual stocks can potentially offer higher returns but at the same time, increased risk is associated with a single company vs diversified over multiple companies (mutual fund) or an index (ETF). As for taxation, stocks are often considered most efficient since long-term capital gains are taxed significantly lower than most other tax rates. Stocks also allow for a step up in cost basis when it comes to ownership transfer at death.
In conclusion, the choice between mutual funds, ETFs or stocks depends on one’s investment objectives and risk tolerance. ETFs are a low-cost, passively-managed option and usually outperform during growth markets. Mutual funds may suit those seeking a professionally-managed portfolio, especially important during times of high volatility or down markets. On the other hand, individual stocks may offer higher returns for those willing to research them and tolerate higher risk. This isn’t to say you cannot hold all three in a diversified portfolio or that if you hold all three, you have diversified your portfolio. When a portfolio is constructed, risk tolerance is of utmost importance. Irrespective of the investment vehicle chosen, it is imperative to conduct thorough research, understand the associated risks and have a long-term investment strategy in place.