An often reliable investment choice with a century of existence under its belt, mutual funds may face stiff competition from a newer option called exchange traded funds (ETFs). Is there really an advantage to investing in an ETF vs mutual fund?
Exchange-traded funds and mutual funds are two investment vehicles that can earn investors solid returns and often with moderate risk. But there are a few crucial differences that set them apart. Investors need to understand which of the two investment vehicles better aligns with their investment objectives. Here is a closer look at ETF vs mutual fund, the similarities, differences, and why one might be a better fit for your portfolio than the other.
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What is an ETF?
An ETF is an investment fund that contains a large pool of investments such as stocks, bonds, commodities, options, and even a combination of them, all in one fund. The ETF owns that pool of underlying securities and divides ownership of them into shares.
There are many different investment options available with an ETF product, such as index ETFs, equity ETFs, and sector and industry-specific ETFs, to name a few. Some ETFs are structured to invest primarily in commodities, currencies, and futures. Some ETFs hold stocks that can be specific to a particular sector (such as an Energy stock ETF), by index (representative of a market index such as the S&P 500 Index), by company size (a fund made up solely of large companies or small ones), and by industry (a fund consisting of companies in one industry, like the a retail stock ETF).
An ETF is a versatile investment, providing many options for investors based on their risk profile.
What is a Mutual Fund?
Mutual funds use money from investors to buy a large pool of investments like individual stocks, bonds, money market instruments, and other assets. Like ETFs, investors purchase shares of a fund that invests in many different securities.
There are also different types of mutual funds available for investors. Four of the main types of mutual funds are:
1. Equity funds
Equity funds invest in stocks. There are options within equity funds as well, such as investing in sector-specific equity funds, funds based on the capsize of the company stocks, and index funds.
2. Bond Funds
These are also known as fixed-income funds. Bond funds can also be specific to corporate, government, and municipal bonds.
3. Hybrid Funds
Hybrid funds invest in two or more different asset classes, such as investing in both stocks and bonds in the same fund.
4. Money Market Funds
Money market funds invest in cash, short-term debt, and government securities. This type of fund is usually considered a temporary parking spot until investors move it to a longer-term investment since the yield can be low.
How is ETF vs Mutual Fund Similar?
1. Provide Similar Investment Options
Both ETFs and mutual funds provide a wide array of options for investors. Index funds, sector-specific funds, commodities, and company capsize are just a few of the similar products available to investors.
With both an ETF and a mutual fund, a single purchase allows shareholders to access a diversified portfolio of hundreds and even thousands of stocks and other securities. Diversification allows investors to own a fund that won’t experience the volatility and level of risk that owning an individual stock in a company would likely have.
3. Professional Management
An ETF and a mutual fund are both professionally managed. As the funds often contain hundreds and even thousands of stocks and other securities, professional management helps select and trade securities within the fund to align with its investment objectives.
ETFs and mutual funds are open-ended funds. Pooled funds typically have continuous contributions and withdrawals by investors. Managers invest the additional money to keep the fund balanced when more cash enters the fund than is redeemed. If there is a net outflow of money, some of the holdings will be sold by management.
How is ETF vs Mutual Fund Different?
ETFs trade on a stock exchange just like individual stocks. They experience price fluctuations throughout the day, and shares are constantly purchased and sold on the stock market. Also, since ETF shares are bought continuously and sold throughout the day, estimating the share price is easier.
On the other hand, with mutual funds, investors can only buy and sell shares through a fund manager and only at market close after the fund’s net asset value (NAV) is calculated. The fund’s NAV is the total value of its assets less its liabilities, divided by the number of shares outstanding.
The fund’s NAV or share price cannot be calculated until the market closes, so investors won’t know the exact price they are receiving until the end of the trading day.
2. Active vs Passive Management
Most mutual funds are actively managed by finance professionals who buy and sell stocks when necessary.
ETFs can be actively or passively managed. Many ETFs are designed to track the performance of a market index. For example, an ETF that uses the S&P500 Index as a benchmark will contain the same 500 companies in the fund. Since the index ETF matches the market so closely, the ETF can be passively managed.
With mutual funds being actively managed, investors can expect to pay a higher management expense ratio and other fees that would be lower with a passively managed ETF.
3. Fees and Taxes
Investors need to be aware of fees and commissions for different investment vehicles because transaction fees can eat into investment returns. Since many ETFs are passively managed, brokerages have cut commissions to as low as zero. However, look for other costs such as fees associated with redeeming funds earlier than the allowable time.
Investors should inform themselves of any sales commissions for actively managed mutual funds. There could be fees associated with operating the fund and paying for professional management to perform research and analysis.
Mutual funds may also have a higher minimum investment, whereas ETFs generally require the purchase of one share plus any fees and commissions at a minimum.
In terms of taxes, ETFs are more tax-efficient than mutual funds as there is typically less internal trading which would trigger fewer taxable events. An ETF will incur a capital gains tax if the fund is sold outright.
For mutual funds, buying and selling the assets within the fund will trigger a capital gains tax. The capital gains tax from the sale of assets is paid out to every investor who owns shares in the fund in the form of a distribution. While investors receive a cash payout, they may be obligated to pay taxes to the Internal Revenue Service (IRS) on any distributions if the fund isn’t held in a tax-advantaged account.
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ETF vs Mutual Funds
Both ETF vs mutual fund provide many different investment options, diversification, and professional management.
However, ETFs may provide additional benefits:
- Can invest in index funds that match the market without paying management fees to outperform the index
- Greater tax efficiency
- Low minimum investment
- Low commissions and fees associated with being passively managed
- Easy trading and transparent pricing, and greater liquidity
In either case, high commissions and fees can reduce returns. Investors must be informed about all the operating and management costs associated with the funds to ensure that the potential returns are worth the investment.
You can also read ETF vs Index Fund: Which is Best for Your Portfolio by the same author.
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Nadia Tahir is a freelance writer and content creator. She mostly writes in the areas of lifestyle and personal finance. She also enjoys writing on her blog about motherhood at This Mom is On Fire.