Investing is an important aspect of long-term financial planning. While you can put your money in a savings account or a certificate of deposit, investing in securities such as stocks and bonds can offer you better long-term returns. Building a portfolio of stocks and bonds that you like is one of the most difficult aspects of investing. Mutual funds, ETFs, and ETNs are ways to invest in pre-built portfolios quickly and easily. Each has distinct advantages and disadvantages. They differ in many ways, and each has its own set of risks that should be considered before investing.
What is an ETF?
An exchange-traded fund is a collection of financial assets that are exchanged on a stock market. They are available on almost every asset class imaginable, from standard investments to so-called alternative assets such as commodities and currencies. Furthermore, new ETF formats enable investors to short markets, gain leverage, and avoid paying short-term capital gains taxes.
ETF shares fluctuate in price throughout the day, depending on supply and demand. When you purchase an ETF, you are purchasing a collection of assets that you may buy and sell, possibly minimizing your risk and exposure while also diversifying your portfolio.
Pros
Diversification
It has a wide range of market verticals, such as stocks, bonds, and it also allows investors to diversify across horizontals, such as industries. Diversification can help protect your investments from market fluctuations.
Transparency
Many ETFs are indexed-based, which means they must publish their holdings on a daily basis.
Trading transactions
Investors can place a range of order types e.g., limit orders or stop-loss orders.
More tax efficient
ETFs only incur capital gains taxes when you go to sell the investment. This means you’ll pay less tax on your ETF investment overall. Also, you get to decide when to sell, making it easier to avoid those higher short-term capital gains tax rates.
Cons
Costs of trading
The expense ratio of an ETF may not be the only cost. ETFs may be subject to commission costs from internet brokers, some brokers have removed the cost though
Liquidity issues
When it comes time to sell, you’ll be at the whim of current market values, just like any other security, but ETFs that aren’t traded as regularly can be more difficult to sell.
The possibility of the ETF closing
The main cause for this is that a fund’s assets are insufficient to meet administrative costs. The most inconvenient aspect of a closed ETF is that investors are forced to sell sooner than they expected – and possibly at a loss.
What is an ETN?
An exchange-traded note is a loan instrument issued by a financial entity, such as a bank. It has a defined maturity time, which is usually between 10 and 30 years. It can be traded according to supply and demand.
ETNs, unlike conventional debt instruments, do not generate interest income for the lender. The investor’s gains or losses are determined by the performance of the asset class or index that it follows. The investor can sell the ETN before it matures or wait until it matures to receive the returns.
Pros
Savings on taxes
ETNs are classified as a long-term capital gain, which obtains preferential treatment (a 20% tax rate) over short-term capital gains. Investors do not get any money, and any profit (or loss) is held until the ETN is sold or matured.
Access to some markets
ETNs offer small investors access to markets for specific securities such as currency, commodities futures, and overseas markets.
Performance tracking that is accurate
Rebalancing is not necessary because the ETN owns no underlying asset. The value of the index or class of assets that the ETN monitors is replicated.
Cons
Liquidity risk
ETN trading activity varies significantly. For ETNs with very low trading activity, bid-ask spreads can be exceptionally wide.
Credit risk
Any investment transaction exposes the investor to market risk. The investor will not receive the principle or the return if the borrowing institution defaults. Even bad news regarding the issuer can affect the ETN’s price.
Investing possibilities are limited
ETNs have a lower demand than many other goods, therefore there are fewer possibilities and prices might vary greatly. The issuing entities make every effort to maintain consistent valuations, however the methods used can cause swings.
What are mutual funds?
This is a type of financial vehicle that pools money from multiple investors to invest in securities such as stocks, bonds, money market instruments, and other assets. Professional fund managers manage mutual funds, allocating assets and attempting to generate capital gains or income for the fund’s investors. Its portfolio is built and managed to meet the investment objectives indicated in the prospectus.
Mutual funds provide access to professionally managed portfolios of shares, bonds, and other securities to small and individual investors. As a result, each stakeholder shares in the fund’s gains and losses proportionally.
Pros
Professional Management
Professionals keep a close eye on the portfolio of the fund. Furthermore, the manager has more time to select investments than a retail investor.
Investment Diversification
A mutual fund, unlike a single stock or bond, invests in a variety of asset classes. This helps to lower the investors risk if one company fails.
Liquidity
Mutual funds have a lot of liquidity. In general, you can sell your mutual funds in a short amount of time if necessary for the current net asset value plus any redemption fees.
Cons
Operating Expenses and Management Fees (MER)
The MER of mutual funds is often large. This reduces the overall profit. For example, if a mutual fund earned a 10% annual return, the MER would reduce that return.
Control Issues
There is a loss of control while investing in mutual funds because they are handled by a manager. When you invest in a mutual fund, keep in mind that you are entrusting your money to someone else to handle.
Performance Issues
According to studies, the vast majority of mutual funds fail to outperform major market indices such as the S&P 500. They are also not guaranteed against losses.
Summary
ETFs, ETNs, and mutual funds are simple and popular solutions to diversify a portfolio with a single transaction. An ETF represents a share in a bundle of assets. ETNs are unsecured debt securities that track an underlying index of securities and trade like stocks on a major exchange. A mutual fund is a pool of money that is professionally managed by a Fund Manager. When deciding which sorts of funds are best for your goals, timeline, and risk profile, it is advisable to consult with a financial expert or do your own in-depth research.
