When it comes to investing, you might find yourself weighing the options between mutual funds and ETFs. Both offer diversified portfolios, but did you know that ETFs typically have lower expense ratios compared to mutual funds? Understanding the differences between these two investment vehicles could impact your financial future significantly.
In this article, we’ll break down the key distinctions, benefits, and potential drawbacks of mutual funds versus ETFs, helping you make an informed decision. If you’re unsure which option suits your financial goals, this guide is essential for you.
Overview of Mutual Funds vs Etfs
Mutual funds and exchange-traded funds (ETFs) are both popular ways for people to spread out their investments, but they work a bit differently. ETFs can be bought and sold throughout the day, just like stocks. In contrast, mutual funds can only be bought or sold at the end of the trading day, with the price set based on the value of the assets they hold.
Mutual funds have been around for almost a hundred years, with the first one starting in 1924. ETFs are much newer, with the first one launching in January 1993 the SPDR S&P 500 ETF Trust (SPY).
Most mutual funds are actively managed, meaning that fund managers decide how to invest the money. On the other hand, ETFs are usually passively managed and simply follow the performance of a market index or a specific industry. But this difference has become less clear over time. Many mutual funds now track indexes passively, and there are more and more ETFs that are actively managed, giving investors a lot of choices in how they want to invest.
Mutual Funds
Investing in mutual funds typically requires a higher upfront amount than investing in ETFs. While some funds don’t have a minimum investment, most retail mutual funds ask you to invest between $500 and $5,000 to get started.
These minimum amounts can differ based on the type of fund and the company offering it. For instance, the Vanguard 500 Index Investor Fund Admiral Shares needs you to invest at least $3,000, while The Growth Fund of America from American Funds only asks for a $250 initial investment.
Mutual funds are often actively managed by professionals who work to pick and choose stocks or other investments to try and outperform the market. Because of the time and effort involved, these funds usually come with higher costs.
When you buy or sell mutual funds, you’re dealing directly with the fund itself, not other investors. The price of the fund, called the net asset value (NAV), is only calculated at the end of each business day. So, you won’t know exactly what price you’ll get until the day is over.
Types of Mutual Funds
Mutual funds come in two main types: open-ended and closed-end. The difference between them has to do with how the fund shares work.
Bond Funds (Fixed-Income Funds):
- Invest in bonds or other debt instruments.
- Focus on providing regular income with lower risk compared to equity funds.
- Categories: Government bond funds, corporate bond funds, and high-yield bond funds.
Equity Funds:
- Invest primarily in stocks.
- Aim for long-term capital growth.
- Categories: Large-cap, mid-cap, small-cap, sectoral, and thematic funds.
Money Market Funds:
- Invest in short-term, high-quality debt securities like Treasury bills and commercial paper.
- Aim to provide liquidity, preservation of capital, and modest returns.
- Low risk but lower returns compared to other mutual funds.
Balanced Funds (Hybrid Funds):
- Invest in a mix of equities and fixed-income securities.
- Aim to provide a balance of growth and income.
- Categories: Aggressive hybrid funds, conservative hybrid funds, and dynamic asset allocation funds.
Sector and Industry Funds:
- Focus on specific sectors like technology, healthcare, or energy.
- Higher risk due to lack of diversification across different sectors.
- Suitable for investors with strong convictions about specific industries.
Index Funds:
- Aim to replicate the performance of a specific market index, like the S&P 500.
- Typically have lower fees due to passive management.
- Provide broad market exposure with less risk of underperforming the market.
International and Global Funds:
- Invest in securities from markets outside the investor’s home country (International) or worldwide including the home country (Global).
- Provide exposure to foreign markets and currencies.
- Higher risk due to geopolitical and currency risks.
Exchange-Traded Funds (ETFs):
- Similar to mutual funds but traded like stocks on an exchange.
- Often track a specific index, sector, or commodity.
- Offer flexibility in trading but may have brokerage fees.
Socially Responsible Funds (ESG Funds):
- Invest in companies that meet certain environmental, social, and governance (ESG) criteria.
- Focus on ethical investing alongside financial returns.
Target-Date Funds:
- Designed for investors with a specific retirement date in mind.
- Adjust the asset allocation mix over time, becoming more conservative as the target date approaches.
- Convenient for long-term retirement planning.
Exchange-Traded Funds (ETFs)
ETFs, or exchange-traded funds, are affordable for most people, as you can buy just one share plus some small fees. Big investors create or take apart these funds in large chunks, but for regular people, ETFs trade on the stock market just like individual stocks, meaning you can buy or sell them throughout the day. Like stocks, you can also “short sell” ETFs, which means betting that the price will go down. While this might interest short-term traders, it’s not a big deal for those who are investing for the long haul.
One thing to be aware of is that because ETF prices are always changing throughout the day, they might not match the actual value of the assets they hold, which can lead to opportunities for traders to make a profit from the difference.
ETFs also come with some tax benefits. Since they’re usually passively managed (they just follow an index rather than trying to beat it), they typically trigger fewer capital gains taxes compared to actively managed mutual funds, where managers are buying and selling more frequently.
ETFs Formation and reclamation
ETFs (Exchange-Traded Funds) are created and redeemed in a unique way that sets them apart from other investments.
To create an ETF, a special broker called an Authorized Participant (AP) gathers the stocks or assets that the ETF is supposed to track. These are given to the ETF provider, who packages them into the ETF. The ETF shares are then sold on the stock market like regular stocks.
When an ETF is redeemed, the AP buys back a large amount of ETF shares from the market and exchanges them with the ETF provider for the underlying stocks or assets.
In simple terms, creating an ETF is like filling a basket with items and selling pieces of it, while redeeming is like returning those pieces to get the original items back.
The Pros of ETFs
- Transparency: ETFs (Exchange-Traded Funds) are like open books. They regularly tell you what they own, so you always know where your money is going. Mutual funds, on the other hand, only share this information every three months and with a bit of a delay.
- Tax efficiency: ETFs usually have a tax advantage over mutual funds because of the way they operate. This can save you money when it comes to taxes. If you want to dig deeper, you can look into how ETFs compare to mutual funds in terms of tax benefits.
- Intraday liquidity: This fancy term just means you can buy or sell ETFs at any time during the day while the stock market is open. So, if the market starts to drop at 10 a.m., you can sell your ETF right then. With a mutual fund, you’d have to wait until the market closes, which might not be ideal.
- Lower costs: ETFs often come with lower fees than mutual funds, though not always. Here’s why: when you buy a mutual fund, the company selling it has to do a lot of paperwork—keeping track of who you are, where you live, and sending you updates. But when you buy an ETF, your brokerage takes care of all that, which means fewer expenses, and that usually translates to lower costs for you.
- Greater flexibility: Since ETFs trade like stocks, you can do more with them compared to mutual funds. You can sell them short, trade them on margin, or even write options on them, which gives you more ways to use your investment.
The Cons Of ETFs
- Trading Costs: ETFs usually have low fees, but buying and selling them might cost extra, especially if you’re not using a brokerage that doesn’t charge commissions. If you trade a lot, these costs can add up.
- Tracking Error: ETFs are designed to follow the performance of a certain index, but they might not match it perfectly. Differences in performance can come from things like management fees or the way the ETF is set up.
- Over-Diversification: If you buy several ETFs that cover similar areas or types of investments, you might end up with too much diversification, which could reduce your potential gains.
- Market Risk: ETFs, like all stocks, are affected by market ups and downs. If the market drops, the value of the ETF is likely to drop too.
- Liquidity Concerns: Some ETFs aren’t traded very often, which can make it harder to buy or sell them at the price you want. Less liquid ETFs might have larger differences between buying and selling prices.
- Tax Considerations: ETFs are usually good for taxes, but they can still have tax effects, especially if they hold a lot of gains or are traded often.
- Complexity: Some ETFs are designed for specific purposes, like making bigger profits or betting against the market. These can be complicated and might not be right for everyone. It’s important to understand how they work before investing.
Bid-Ask Spread: ETFs are bought and sold on stock exchanges, and their prices can have differences between buying and selling. A bigger spread can make it more expensive to trade, especially for ETFs that aren’t traded much.
| Feature | ETFs | Mutual Funds |
| Trading | Traded on an exchange like stocks | Bought and sold through the fund company |
| Pricing | Prices fluctuate throughout the trading day | Prices are set at the end of the trading day |
| Management Fees | Typically lower fees | Often higher fees |
| Minimum Investment | Generally no minimum investment | May require a minimum investment amount |
| Tax Efficiency | Generally more tax-efficient | Can be less tax-efficient |
| Transparency | Holdings are disclosed daily | Holdings are disclosed less frequently |
| Investment Strategy | Can be passively or actively managed | Can be passively or actively managed |
| Dividends | Paid out quarterly or as they are received | Usually paid out quarterly |
| Liquidity | High liquidity due to continuous trading | Liquidity depends on the fund’s structure |
| Flexibility | Can be traded any time during market hours | Trades executed at the end of the day |
