Talk to one investor, and they’ll tell you that exchange-traded funds are the best investment around. Another might say to you that mutual funds are still the best way to make money on the stock market.
Both of these investments are excellent choices — if they align with your investing strategy and risk tolerance. They differ in several ways. Deciding which one is better for you means understanding what they are and how they are similar or different.
When considering an ETF vs. a mutual fund, start by learning how to decide which is better for your portfolio and strategy.
What Is an ETF?
Exchange-traded funds are investing tools that use the power of communities to attempt to increase in value. Investors trade capital for units of the shares that the share managers own. Essentially, you’re investing in someone else’s investment alongside other investors.
As a simple example, say you’re a broker, and you purchase 10 shares each of companies XYZ, ZYX, YZX, and ZXY. These shares become the fund. You divide them up into units and trade those units electronically on an exchange.
Investors purchase and sell these units for profit or loss. You make money from the transactions and receive any dividends from whichever company issued the stock (if they distribute dividends). You can distribute the dividends to your shareholders, reinvest them into the fund or keep them — depending on if your fund is a dividend ETF or not.
Exchange-traded funds are usually designed to track an index, such as the S&P 500 stock index. For that reason, indexed ETFs generally have low turnover rates within the funds. Fund managers can manage ETFs as they see fit, but in general, they are passively managed.
ETFs don’t have to be based on stocks; they can be created from bonds, commodities or foreign currency.
ETFs can be traded throughout the day as investors make purchase and sell orders. This makes them appealing to investors who have the time and desire to focus on trading, like day traders.
What Is a Mutual Fund?
Like ETFs, mutual funds are professionally managed pools of capital contributed by investors. The difference is that mutual fund shares are sold directly to the investors by the fund companies themselves rather than traded as units of the underlying stock or asset on an open stock exchange.
Mutual funds receive their change in value at the end of the trading day because they are based on the underlying asset’s closing price. The closing price is the asset’s price at the end of the trading day when the market closes.
Mutual funds are companies that own stocks of other companies. Investors buy into a fund, and the managers use the capital to invest in stocks, bonds or different investment types.
Fund managers can sell or add stocks to their fund as needed to keep the fund aligned with the investing strategy they use. If the fund is targeted for growth and one stock is underperforming, they can sell it and purchase another that’s performing well.
What’s the Difference Between ETFs and Mutual Funds?
Both ETFs and mutual funds take investor funds and manage them according to the written strategy. Both have the potential to offer diversification at lower costs, providing investors with the opportunity to access nearly any investment type.
Here’s a look at the similarities and differences:
|Expense Ratio||Typically lower than mutual funds||Typically higher than ETFs|
|Trading Time||When exchanges are open||Once per day after the market closes|
|Professional Management||Both active and passive||Both active and passive|
|Taxation||Capital gains limited to specific types and occurrences||Capital gains and income passed to shareholders when shares sell for profit|
Trading Costs and Expense Ratios
There have always been several no-load mutual funds, but many ETFs are free of trading costs. The costs of trading ETFs are significantly reduced compared to the past, as several brokerage firms have eliminated commissions on stock and ETF trades.
Generally speaking, traditional mutual funds have higher overall expense ratios than ETFs. Buying shares of a mutual fund directly from a management company involves more paperwork, which is part of the reason mutual funds cost more than their exchange-traded counterparts.
ETFs carry lower expense ratios on average. This can be demonstrated by comparing ratios between mutual funds and ETFs from a popular brokerage service. Vanguard, one of the top brokerages, lists its mutual funds and ETFs together for quick reference.
Professional money managers oversee both mutual funds and ETFs. 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.
Mutual funds can be passively managed as well. However, they generally track a market index and are called index funds. For example, the Vanguard Total Stock Market Index Fund Admiral Shares (VTSAX) is passively managed, only requiring changes when the underlying index is changed.
ETFs can also be actively managed if they are designed to follow a specific strategy. Take ARK Innovation ETF (ARKK), for instance — it is actively managed to follow the most innovative stocks on the market at any given time.
ETFs tend to be more tax-efficient than mutual funds. Traditional mutual funds must continuously buy and sell securities as assets enter and leave the fund. This creates capital gains that are taxable.
ETFs are structured to make it easier for their managers to offset gains and losses, thereby reducing the tax liability for shareholders.
Trading Margins, Options, or Shorting
ETFs are more flexible than mutual funds. You can trade ETFs on margins but can’t with mutual funds. You can also write options against ETFs or sell them short.
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 sale.
Exchange-traded funds regularly report their holdings, sometimes disclosing their entire portfolios on their company web pages. Mutual funds are only required to report their holdings quarterly, within 60 days of the period’s end.
Choosing Between Mutual Funds and ETFs
Which is better? It depends entirely upon your preferences. Your choice of investment strategies defines which type of investment you choose. Here’s a look at what you should consider when deciding between ETFs and mutual funds.
Level of Attention and Risk
ETFs generally require more attention from investors than mutual funds. If you prefer to be more involved in trading and want to do it throughout the day, ETFs are excellent. However, it is easy to fall into the risky business of trying to time the market and trade more volume when following ETFs.
Mutual funds are excellent for making regular, automated, long-term investments. Mutual funds are not without their risks — inflation and interest rate risk can devalue mutual funds over longer periods unless you’ve taken steps to hedge the risk.
Tax-conscious investors might lean toward ETFs over mutual funds because mutual funds must make distributions of capital gains. Investors in exchange-traded funds can often avoid paying capital gains due to how they are structured.
Expense Ratios and Initial Investment Requirements
ETFs tend to have lower fees, expense ratios and initial investment requirements. The Vanguard Total Bond Market ETF (BND) has an expense ratio of 0.035%, with prices set fairly low — the 52-week high for 2020 was $89.36, and the 52-week low sat at $82.47 per share.
Mutual funds generally have higher expense ratios than ETFs, but they can be low as well. For example, the Vanguard 500 Index Fund has an expense ratio of 0.04% and only requires a $3,000 initial investment.
Choose the type that fits your investment preferences and wallet. When you’re budgeting for a mutual fund or ETF, be sure to never invest more than you can afford to lose.
Selecting the Right Option for You
Deciding between ETFs and mutual funds can be a challenge. It helps to have someone looking out for your best interests. Consider working with a fiduciary financial advisor to help you make the best investment decision for you.
- Housing Breaks That Are Available to Military Members and Their Families
- Everything You Need To Know About Taxes This Year
- 4 Tips for Saving Money While in the Military
- Big Personal Goals That You Should Put Your Money Toward
John Csiszar contributed to the reporting for this article.