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Exchange Traded Funds (ETFs) vs. Mutual Funds in IRAs

Posted by Thomas M. Anichini, CFA, GuidedChoice Director of Research on May 29, 2018 2:26:40 PM
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When comparing IRA offerings, some vendors offer ETFs only, some offer open end mutual funds only, some offer both. This article discusses the differences between exchange traded funds vs. mutual funds to help you decide whether you require either or both in your IRA.

Mutual funds: Time tested, foolproof, and often costlier

Mutual funds have existed in the US since the early 20th Century. For decades you could invest via the USPS. While technology has advanced such that you may now invest in mutual funds via the internet, one feature remains unchanged: mutual funds are priced once per day at their net asset value (NAV).

Being priced at the NAV makes mutual fund investing rather dull. Look up a mutual fund’s price and you won’t find an intraday chart, since its price won’t be struck until after trading ends. All this means that investing in or redeeming mutual fund shares is nearly foolproof: you don’t need to understand much about investing or anything about trading in order to do it competently.

Investing in mutual funds can be costly:

  • All funds charge an expense ratio to pay its management and operations. Fees are skimmed out of the fund’s net assets each day, so you would never notice an explicit withdrawal – instead you simply earn an almost imperceptibly lower return each day.
  • Some funds (about 40%) charge a load, which is an additional sales charge. A front-end load of 5.5% means that for every $1,000 you purchase, you’re putting $945 to work, and that other $55 went to pay sales channels.
  • Although some funds are quite inexpensive, they tend to have high minimum investment requirements such that they are available only to institutional investors or very high net worth individuals

ETFs: Newer, typically less expensive, not foolproof

ETFs have been around some 25 years. However, unlike mutual funds, ETFs trade on an exchange just as common stocks do. Their prices fluctuate throughout the trading day, and they can even trade at a price different from their NAV, which you can only estimate during the day. This is one of the core differences when looking at exchange traded funds vs. mutual funds in IRAs.

Further, ETF prices are quoted at two different prices: the bid price and the ask price. The bid represents the highest price at which a willing buyer will spend; the ask (aka “offer”) represents the lowest price at which a willing seller will sell you the shares. The bid is lower than the ask, and the difference is called the bid-ask spread. The spread can be quite small (fractions of a percentage point) for very liquid stocks and ETFs, but it can be significant (multiple percentage points) for illiquid ones.

Even if you can trade without commissions, the bid-ask spread remains a cost you will bear when you trade ETFs. As a conservative estimate, assume you will have to pay the bid-ask spread when you buy and when you sell an ETF. That is, you will buy at the ask and sell at the bid.

Further, trading illiquid stocks and ETFs can be treacherous. Human and robot traders will gladly take advantage of you if you do not know what you are doing. It is important to learn about using limit orders when trading ETFs.

Vendors Offering IRAs

IRAs abound. You can start IRAs with banks, credit unions, insurance companies, fund companies, and brokerage firms. Some of these non-broker entities have relationships with a brokerage firm, so they can include a brokerage trading facility and access to ETFs.

The GuidedChoice IRA is an arrangement with InspiraFS as a record-keeper. Neither GuidedChoice nor InspiraFS is affiliated with a brokerage firm, so we do not include ETFs in our IRA offering.  However, the funds we use are mostly low-cost index mutual funds without any front-end or deferred load. The median expense ratio is 0.155%, or 15.5 cents per $100. What is even better is that our IRA is a “pay what you see” model which means you don’t need to dig for your fees, we show you exactly what it will cost you. If you want to see more information about the funds we use or our portfolios, click here.  Learn more about our professionally managed IRA that takes the stress out of investing.

Topics: Near or in Retirement, All, Featured, Saving for Retirement, ETFs, no fee ira, exchange traded funds vs. mutual funds, IRA Rollover, low fee ira

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