ETFs or Mutual Funds? And Active or Passive?


Dear Dr. Don,

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Do you recommend investing in actively managed mutual funds or exchange-traded funds?

Thank you,

-Jeff Juncture

Dear Jeff,

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That's a complex question. There's the more basic choice between investing in mutual funds or exchange-traded funds, or ETFs, and then the decision of whether to pursue an active investment strategy.

First, we need to distinguish between trading and investing. A trader moves in and out of financial securities trying to capture short-term price changes. A trader would lean toward ETFs because they trade intraday, while mutual funds trade at the end of the day. A trader also would be attracted to ETFs because they don't have the redemption fees and other features that many mutual funds have implemented to discourage people from trading in and out of their funds.

So, a trader would lean toward ETFs. An investor can make the case for either type of investment vehicle.

Active management of your investment portfolio means your investment managers look to "beat the market." With a passive investment strategy, such as indexing, the investment manager is looking to "be the market."

Active management is more expensive than passive management. For active management to pay off, the active manager has to earn a return, after fees and expenses, higher than the passive manager's indexed investment after fees.

A nice compromise is to use a core-satellite portfolio strategy, where your core holdings are passively managed, earning market returns and paying low expense ratios, while you also have a satellite portfolio or portfolios for active-management decisions.

ETFs started out by mimicking the indexed mutual funds but have since expanded their horizon into actively managed investment vehicles, commodities and even derivatives. There can be tax advantages in ETF investing, but there also can be tax traps. There really is no substitute for reading the investment prospectus with these investments to understand what's held in the ETF and the tax ramifications of investing in it.

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