Mutual Funds Or ETFs: Work Horses Of Your Investing Strategies

Whether you're an experienced investor or a novice, ETFs and mutual funds can play an important role in your investment portfolio. Chances are they already do. The question is whether you're using the best investing strategies. Are you getting the most out of those investment vehicles?

Many investors already invest in mutual funds and ETFs. If you have a 401(k) or an Individual Retirement Account (IRA), you almost certainly invest in mutual funds or ETFs. And there's a good reason: funds and ETFs have shown trustworthiness for decades. They offer investors affordable access to stocks, bonds and more investments. And they're governed by strict regulations.

Lured by such advantages, 46% of U.S. households owned mutual funds as of the end of 2019, according to the Investment Company Institute (ICI). That was up from 42% at the end of 1999.

Investing Strategies: You Can Choose From Among Many Building Blocks

ETFs and mutual funds come in a vast array of types and styles. They can fit into many investing strategies. You've got diversified stocks and bonds, sector funds and foreign funds. You can choose between index funds that track the S&P 500 and actively managed funds that use professionals to monitor and optimize the portfolio.

Moreover, there are target-date funds that gradually change investment holdings to match your risk tolerance as you get closer to retirement. There are factor-based funds that focus on growth and value as well as big-cap and small-cap stocks.

The first step in creating or improving your investment strategy is to decide what kind of investor you are. This involves setting a date when you'll need the money. If it's a long time from now, you can accept more volatility in prices along the way. That makes a greater percentage of stocks suitable. If you'll need your money in the next couple of years, you'll want more stable assets like cash and shorter-term bonds.

When you need your money helps determine what phase of investing you're in on a spectrum from wealth building to a mix of wealth building and spending.

Next, it's time to structure your portfolio. Many brokers, mutual funds and ETF providers offer software you can use to build a portfolio of ETFs and/or mutual funds, aiming for the best possible return for the amount of risk taken. Financial advisors at those outfits or who operate independently can provide hands-on help.

After setting your investment game plan, stick to it. "Discipline is critical," said Chad Roope, chief investment officer of Fundamentum Investment Management. "If parts of your portfolio — your technology stocks, your small-cap stocks, your bonds, whatever — have grown much bigger or smaller than your plan calls for, it's time to rebalance."

A Fund For Any Investing Job

When building your portfolio, your investment choices include mutual funds and ETFs. Which is right? It depends. You might hold ETFs in one part of your portfolio and mutual funds in another.

ETFs that track an index are often cheaper and are more tax-efficient when held outside of a retirement account like a 401(k) or IRA. But at some point you may want exposure to an actively managed mutual fund that outperforms its benchmark.

Mutual funds and ETFs provide the leave-the-driving-to-us professional assistance that many retail investors crave. As a result, they're all that's offered by most 401(k) plans.

Their efficiency is a big reason why mutual fund assets ballooned to $22.7 trillion as of Aug. 31, according to the ICI. ETF assets hit $4.8 trillion.

Among the biggest fund companies, Vanguard runs $4.8 trillion for shareholders, according to Morningstar Direct. Fidelity Investments and American Funds followed with $2.8 trillion and $1.9 trillion.

In ETFs, BlackRock's iShares led with $1.8 trillion. They were followed by Vanguard's $1.3 trillion and State Street's $785 billion.

Curiously, stock performance has boosted asset levels in stock mutual funds even as investors yank money from them. Shareholders pulled a net $375 billion from stocks funds in the first eight months of the year, according to the ICI. The S&P 500 has rallied about 9%. The stock fund outflow is a continuation of a multiyear retreat from mutual funds, largely from actively managed portfolios into index funds, including ETFs.

Active managers in categories like taxable bond funds and municipal bond funds have continued to lure net inflow by demonstrating their value.

How Should You Invest Right Now?

The key, big-picture question for retail investors is, How should I invest in funds right now, in this tortured world and uncertain market, to reach their goals, such as generating income and making their capital, their principal, grow and grow?

"Market volatility can disrupt an investor's concentration and lead them away from their objective," said Viraj Desai, a senior portfolio manager for TD Ameritrade Investment Management. "At times like this, it's important to stick to your guns, to your investment game plan."

How Much Of Your Portfolio Should Be In Stock Funds?

If you are young, your investment objective should focus on building your account balances.

In late middle age, you might want to take a little risk off the table by adding some bond funds to your portfolio.

And as you approach and enter retirement, you'll likely boost your bond weighting to dampen volatility.

Those rules of thumb translate into a stock weighting of about 95% in your twenties and thirties. It declines until it is about 65% by your late sixties. At any age, it can be higher or lower, depending on your goals, time horizon and risk tolerance.

Investing Strategies For The Long Haul

When it comes to reaching your objectives with the funds portion of your portfolio, the words "long term" are a key.

Feel free to go to cash or high-quality bonds for the spending bucket in your portfolio. That's the portion of your portfolio that you expect to liquidate within, say, two years to pay for specific goals like your grandkid's tuition.

But don't mess with the asset allocation spelled out in your investment game plan, with the long-term bulk of your portfolio, unless you have a sound, proven system for doing so.

Amid a fluctuating market? It's OK to make subtle portfolio tweaks, which don't violate the stay-the-course rule.

For instance, if you expect continued outperformance by U.S. large-cap stocks, you can cut volatility by shifting slightly into U.S. and large-cap stocks, away from foreign and smaller-cap stocks. That does not deprive you of growth from stocks.

How To Divvy Your Portfolio Between Mutual Funds, ETFs

How should you divvy up your portfolio between mutual funds and ETFs? Both provide diversification.

Use ETFs for exposure to parts of the market that lend themselves to index investing, says Rich Powers, Vanguard's head of ETF product management. That's because ETFs tend to be low cost and most ETFs track indexes.

For instance, if you invest in the S&P 500, do it at the lowest possible cost via an index fund.

But for exposure to stocks, bonds or any security whose pros and cons require the insight of a fortuneteller and the numbers-crunching skills of an Einstein, look for an active portfolio manager with a long track record of outperformance. That's how you justify the likely higher fee, Desai says.

Investing Strategies: Why 401(k) Plans Typically Offer Mutual Funds, Not ETFs

As you mull your investing strategies, don't worry about how to mix mutual funds and ETFs in your 401(k) account. Generally, the only way you can invest in an ETF in a 401(k) account is if your plan offers a self-directed brokerage feature.

One reason is that ETFs trade throughout the day like stocks. That's contrary to the long-term focus that plan sponsors want employees to have with retirement accounts, says TD Ameritrade's Desai.

And low-cost index mutual funds can provide long-term exposure to important asset classes without encouraging plan members to think short-term, Desai adds.

In addition, in taxable accounts you can also trade partial shares of ETFs. That can cut trading costs. But in your 401(k) plan, you typically have access to institutional shares of mutual funds "that offer lower costs than ETFs," said Vanguard's Powers.

Also, ETFs do not have to sell underlying holdings to cope with outflows the way that mutual funds tend to. That means ETF shareholders get socked with smaller capital-gain tax bills. But inside a 401(k) account, where investments are sheltered from such year-by-year taxes, ETFs would not have a tax edge.

Bottom Line

Omar Aguilar, a senior vice president who is responsible for Charles Schwab Investment Management's equity and asset allocation mutual funds, ETFs and separately managed accounts (SMAs), says the crux of the mutual funds-or-ETFs choice is that mutual funds are great for retirement accounts.

"Mutual funds tend to have long time horizons," he said. "You don't have to worry about whether they are tax efficient because they are in retirement accounts (where capital gains and other distributions are not subject to tax). You can get lots of flavors of funds at decent costs. And because mutual funds get priced only once a day and don't involve questions of tax-efficiency (if they're in retirement accounts), they're simpler to use and trade."

TD Ameritrade's Desai — whose company's customers use many types of securities — provides a bottom-line perspective to the question about how to use funds in your investing strategy. "Once you understand how to use each type of fund, the choice is easy," he said. "Use them both."

Reprinted from yahoofinance, the copyright all reserved by the original author.

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