There might always be a debate in the financial world about whether mutual funds or exchange-traded funds are a better investment option, but the key is to choose which option — mutual fund or ETF — is best for you as an investor. Both are individual investments that provide access to professionally managed portfolios that might contain hundreds or even thousands of securities, such as stocks or bonds. However, they differ in many key ways, including how much they cost and how you can purchase them. To help you decide which choice is better for you, here’s a look at the ins and outs of both mutual funds and ETFs, including their similarities and differences.
- What Is an ETF?
- What Is a Mutual Fund?
- What Is an Index Fund?
- What Is the Difference Between an ETF and a Mutual Fund?
- How To Choose Between Mutual Funds and ETFs
- Which Investment Vehicle Is Right for Me?
What Is an ETF?
The key to understanding the hybrid investment known as an ETF lies in its name: exchange-traded fund. Like a mutual fund, an ETF is an investment pool that collectively invests in securities on behalf of shareholders. The “exchange-traded” part comes in because, like a stock, ETFs are traded on a public stock exchange.
ETFs are good options for investors who want the diversification and professional management that comes from a mutual fund, but who also want the ability to buy and sell shares at any time the market is open. You can learn more about these hybrid investments in GOBankingRates’ complete guide to ETFs.
What Is a Mutual Fund?
Like ETFs, mutual funds are also professionally managed pools of investable capital contributed by shareholders. The difference is, mutual fund shares are sold directly to investors by the fund companies themselves rather than traded on an open stock exchange. Thousands of mutual funds that cover any investment style imaginable are available. Whether you want to invest in large U.S. stocks, small foreign stocks, emerging market bonds or gold and precious metals, you can find plenty of mutual funds to invest in. Learn more in GOBankingRates’ guide to everything you need to know about mutual funds.
What Is an Index Fund?
An index fund is a special type of fund that tracks the performance of a specified index. For example, the Vanguard 500 Index Fund attempts to replicate the performance of its underlying index: the S&P 500. You can find an S&P 500 fund in the form of either a mutual fund or an ETF, along with other index trackers. Learn more about what an index fund is and if you should buy one.
What’s the Difference Between an ETF and a Mutual Fund?
Both ETFs and mutual funds take investor funds and manage them according to written parameters. Both have the potential to offer instant diversification at low cost and provide investors with the opportunity to access nearly any investment type imaginable. However, there are important differences between the two. Here’s a look at their similarities and differences across various categories.
Best Mutual Funds for 2019: 6 High-Performing Funds To Diversify Your Portfolio Now
Both mutual funds and ETFs are overseen by professional money managers. However, ETFs are more likely to be passively managed than mutual funds. A passively managed fund is one that simply tracks an index rather than relying on its managers to make investment decisions.
Generally speaking, traditional mutual funds will have a higher overall expense ratio than ETFs. Buying shares of a mutual fund directly from a management company involves more paperwork, which is part of the reason that mutual funds typically cost more than their exchange-traded counterparts.
Flexibility With Buying and Selling
ETFs have more flexibility in terms of buying and selling because you can trade them any time the stock market is open. Mutual funds are only priced once per day, after the market has closed. If the market is moving rapidly up or down, you can’t do anything about it until the end of the day if you own a mutual fund.
Mutual funds are priced exactly at their fair market value every day. ETFs, on the other hand, trade at whatever the current market price is, which may be above or below their net asset values. Any premiums or discounts are usually minimal, but you might be paying more for your ETF than the actual value of the underlying investments.
Find Out: What Makes a Good Investment?
Exchange-traded funds regularly report their holdings, sometimes disclosing their entire portfolios on their company web pages. Mutual funds, on the other hand, are only required to report their holdings quarterly and with a 30-day lag. By the time you see what your mutual fund owns, it might have an entirely new portfolio.
ETFs are more flexible when it comes to numerous stock-like market transactions. For example, you can trade ETFs on margin, unlike with mutual funds. You can also write options against ETFs or sell them short — things you can’t do with mutual funds.
The landscape of trading costs took a major turn in early October 2019. A number of major brokerage firms — including Charles Schwab, TD Ameritrade, E-Trade and Fidelity — all announced that they were eliminating commissions on stock and ETF trades. Now, you can buy any ETF available without having to pay commissions at any of those firms. There have always been a number of no-load mutual funds, but now any ETF can also be had free of cost.
Holding Period Return
When you own an ETF you earn the difference between your purchase price and your sale price on the open market, plus any dividends. With a mutual fund, you earn the actual net asset value gain or loss from the time of purchase to the time of sale.
Learn More: How Are Mutual Fund Returns Calculated?
ETFs tend to be more tax-efficient than mutual funds. Traditional mutual funds must constantly buy and sell securities as asset flows enter and leave the fund, creating taxable events. The way ETFs are structured makes it easier for their managers to offset gains and losses, thereby reducing the tax liability for shareholders.
|ETFs vs. Mutual Funds|
|Trading Costs||Zero commission ETFs readily available; others require stock commission||No-load funds readily available; others may have front-end loads or redemption fees|
|Expense Ratio||Typically lower than mutual funds||Typically higher than ETFs|
|Index Funds||More common||Available|
|Buying and Selling||Any time stock exchange is open||Only once per day, after the market close|
|Professional Management||Both active and passive||Typically active|
|Taxation||Generally low tax consequences||Required to pass through capital gains and income to shareholders|
Your choice of investment strategies can help define if you are a mutual fund or an ETF investor. Active traders would be better suited to buying ETFs. Because ETFs trade throughout the day, you can react immediately to any market news, good or bad. With a mutual fund, you’ll have to wait until the end of the day to execute any trades. Additionally, some mutual fund companies have short-term redemption fees if you trade more often than every 30 days or so. ETFs might fit the bill if you’re a cost-conscious investor.
ETFs carry lower expense ratios on average. For example, the average equity mutual fund expense ratio in 2018 was 0.55%, whereas the average equity ETF expense ratio was 0.20%. However, some fund companies, including Vanguard mutual funds, do focus on low overall costs.
The largest index mutual fund in the country — the Vanguard 500 Index Fund — carries an expense ratio of only 0.04%. The iShares Core S&P 500 ETF expense ratio also comes in at 0.04%, though that’s slightly above the Vanguard ETF tracking the S&P 500, at 0.03%.
Mutual funds have the edge when it comes to making regular investments, especially in small amounts. Most mutual fund companies allow automated investment, sometimes in amounts of $50 or lower. This can be a great way for beginners or regular investors to save. Monthly investments in a mutual fund typically help you avoid fees. In contrast, if you were to buy regular amounts of an ETF every month, you’d have to pay a separate transaction cost each time.
Mutual Fund Fees: What You Need To Know Before Investing
Tax-conscious investors might lean toward ETFs over mutual funds because mutual funds are required to make distributions of capital gains. Exchange-traded funds can often avoid paying capital gains due to the way that they are structured.
Which Investment Vehicle Is Right for Me?
There is no such thing as an investment that is right for all individuals. Each investor has their own tolerance for risk, their own investment time horizon and their own specific goals for their portfolio. No matter how well an investment performs or how little it costs, it does not necessarily make it a good investment for you. For this (and many other) reasons, GOBankingRates suggests that you might want to work with a fiduciary financial advisor before making such important investment decisions.
Certain types of investors might prefer owning an ETF over a traditional mutual fund. If you’re a more active trader and you need to jump in or out of your investment on a regular basis, an ETF is better suited to your style. If you’re a long-term, buy-and-hold investor, a traditional mutual fund might be a better option. However, as noted above, there are many elements that go into buying an investment — particularly when choosing between an ETF and a mutual fund. To help you make the best decision possible, consider working with an investment professional at one of GOBankingRates’ best brokers so you can be sure to cover all the bases.
More From GOBankingRates