ETFs are similar to mutual funds in most ways: they invest in securities, and they charge fees. But unlike mutual funds, which are actively managed by humans who decide what kinds of stocks to buy or sell, ETFs offer active investors to take charge at the helm and call the shots on their own trading decisions.
Keep reading to know what exactly the two are all about, their similarities and differences, and which is the best investment choice for you.
What is an ETF?
Exchange-traded funds (ETFs) are a popular tool for investing in the stock market. But there are many different types of ETFs, such as equity ETFs, bond ETFs, and commodity ETFs. They work quite differently from the mutual funds most people invest in.
An exchange-traded fund (ETF) is an investment vehicle that tracks a stock market index.
The advantage of this is that you can get exposure to a broad market segment in one purchase, whereas if you were to buy all the stocks in an index individually, you would have to buy a larger number of them. And since most indexes cover large market segments, ETFs can be much more cost-efficient than buying individual stocks.
For example, the SPDR S&P 500 is one of the oldest and most widely known ETFs available to invest in. It tracks the S&P 500 index, which features 500 leading publicly traded U.S. companies on the stock exchange. Investing in this ETF is simpler and more efficient than buying individual stocks of each of those 500 companies.
The ETF’s price will move up and down with its underlying instrument, which refers to whichever stock market index it is tracking. So, for example, if gold goes up in value, gold ETFs will go up in value as well.
Mutual funds, by contrast, have prices that move according to supply and demand for shares; so if gold goes up in value, it won’t necessarily affect mutual fund prices.
Exchange-traded funds also offer advantages over stocks:
Dividends and interest from stocks must be reinvested manually, but with an ETF, all dividends are reinvested automatically.
Because most ETFs track indexes, you don’t have to wait for a company’s quarterly earnings announcement to find out whether it is doing well; you can look up its position in its index.
Finally, because ETFs hold assets in trust for the benefit of their shareholders, they are not subject to corporate governance issues related to management self-dealing.
What is a mutual fund?
In the United States, many investors are familiar with mutual funds. Investment companies house mutual funds, which are pools of money that allow investors to take a stake in many different companies, stocks, or financial instruments at once. Popular mutual funds include the Vanguard Institutional Index Mutual Fund (VINIX), Vanguard Federal Money Market Fund (VMFXX), and Fidelity Government Cash Reserves (FDRXX).
The advantage of mutual funds is that they simplify buying and selling shares of stocks. Rather than having to find a broker and place an order for each new stock you want to invest in, you can open a single account and buy into a mutual fund that tracks the market as a whole.
In addition, because investors pool their resources together, mutual funds offer more liquidity than individual stocks do.
You can buy into various mutual funds with varying goals: growth, income, foreign investments, etc. Some mutual funds charge an upfront sales fee and an annual management fee. These fees eat into your earnings and may be worth it if you don’t have the time or expertise to research individual stocks on your own.
Mutual funds do have disadvantages, however.
One is that there’s no guarantee that a mutual fund will track the market it purports to track; investors must trust their fund manager to keep up with the latest trends in the market, especially in an actively managed fund.
Actively managed means that a fund manager buys and sells securities to beat an index or meet other performance targets. Beating the index is equivalent to beating the market. It means earning a higher return than the one from the index itself. The manager does this by deciding which securities to buy or sell at any given time.
A passively managed fund does not attempt to beat an index; instead, it seeks to match the index’s performance by investing in all the securities included in that index.
Another disadvantage is that mutual funds charge fees for their services; this includes management fees and transaction fees for every purchase or sale made by the fund’s manager.
How are ETFs and mutual funds similar?
Exchange-traded funds (ETFs) and mutual funds are ways to invest in a basket of stocks. ETFs have become more popular in the last decade due to their tax efficiency and liquidity, but most active investors still prefer mutual funds.
They have a similar investment objective
The basic function of both ETFs and mutual funds is to pool investors’ money to afford them the ability to invest in assets that would otherwise be too expensive for any one investor. In both cases, this includes a diversification of assets that lowers risk for the investor (or at least should).
For example, ETFs and index funds have the same goal: to give investors exposure to a particular market or segment of the market at a low cost. The big difference is that an ETF trades on an exchange like a stock, while a mutual fund is traded only once a day after the markets close.
They maintain fund shares on behalf of owners
Both ETFs and mutual funds maintain a portfolio of assets on behalf of their shareholders. The types of assets held in each type of fund may vary considerably and belong to different asset classes, but the idea is always the same; both funds have a portfolio that is considered a single entity, and every shareholder owns a portion of that portfolio.
Both investment vehicles also allow their owners to carry diversified portfolios. Both benefit from the exposure.
They both have elements of active management
One or more individuals who run the fund decide which individual securities or other assets will be purchased or sold and can also choose to trade futures contracts or options on stocks, bonds, or other commodities instead of holding physical securities. Mutual funds have portfolio managers that operate and oversee the fund.
ETFs have the option of being actively managed and, in this way, are similar to mutual funds. However, the majority of the time, they are passively traded funds. ETFs automatically track a pre-determined index like the Nasdaq 100, for example. If you opt for an actively managed ETF, you will encounter higher fees.
How are ETFs and mutual funds different?
They are conceptually different
Most people think of them as competitors, but they’re more like different species that live in the same ecosystem. There’s a sense in which ETFs are more like mutual funds, which is true as both involve investing in a basket of stocks. But the end game is different.
ETF investing is like keeping a copy of a basket of stocks: you own a piece of all the companies it holds. However, your end performance will be only as good as the original index.
Mutual funds are more like individual stocks: each fund has more diversification due to active management and the opportunity to buy and mix different stock baskets. This means the performance can beat the market, or sometimes lower, depending on who manages it.
The minimum investment required
There is no minimum investment for ETFs. Instead, they are purchased as whole shares, and the price of one share is referred to as an ETF’s market price.
On the other hand, mutual funds have benchmark amounts for the minimum investment levels. These are usually a flat dollar amount. However, this can vary depending on the specific mutual fund in question. For example, some Vanguard mutual funds require a minimum investment level of $3,000 at all times.
Trading times and methods
The biggest difference is that you can trade ETFs during market hours. Mutual funds only trade once a day when the market closes. That makes ETFs more tax-friendly if you’re trying to time your trades for a precise moment, but it also means investors who don’t want to pay attention every day might be better off with a mutual fund.
The main advantage of ETFs over mutual funds is that they are traded on exchanges, which makes them transparent. Mutual funds trade in the after-market, which is not as transparent as the regular market.
Also, ETFs trade like stocks, so the share price fluctuations or changes in the value of underlying securities are expected. Mutual fund orders are carried out only once a day, so all mutual fund owners receive the same price.
ETFs may have lower fees than traditional funds because there’s less overhead involved in running them. And because they trade throughout the day, there’s no need to pay someone to manage large orders coming in at once during market hours.
Your brokerage account may have certain costs like the cost of trading commissions, and the fund company will also share the operating expense ratio. In addition, you have the implied costs of the bid-ask spread and premium/discounts to your net asset value (NAV). These costs are implicit and occur when you sell shares on the stock exchange.
Mutual funds might not have brokerage commissions as they can be purchased without them, but there can be higher expenses if an expert financial advisor actively manages the fund. They also carry higher fees, sometimes in the form of sales loads and early redemption fees.
ETFs are subject to capital gains taxes because they are treated like stocks. However, if you hold the fund for a year or longer, you will be taxed on all distributions at long-term capital gains rates. The tax implications may be important for investors who hold ETFs in taxable accounts, depending on their holding period and the type of account.
Mutual funds are structured to tend to incur higher capital gains taxes. As they tend to be actively managed, the sales and purchases of assets in a mutual fund are made more frequently, and the gains are passed onto everyone who has shares in the fund, even for those with unrealized losses.
Overall though, ETF shares have lower turnover, so ETFs offer less taxable returns than mutual funds.
ETF vs. Mutual Fund: What’s right for you
Although the two investment vehicles are similar, ETFs and mutual funds are not identical. Both are pools of money invested in stocks, bonds, or other assets, but each has distinct advantages and disadvantages. What is best for you depends on your own investment goals and strategy, and you can easily ascertain this by reading the fund’s prospectus and knowing what you’re in for.
When you should consider an ETF
The main reason to choose ETFs over mutual funds is the cost. An ETF will most likely be cheaper to buy and sell. The expense ratio for an ETF is an all-in price, meaning that it is the total cost of the investment.
Mutual fund fees:
- A mutual fund’s management fee covers the costs of portfolio managers, trading costs, and research.
- The transaction fee is charged on each purchase or sale of shares in a mutual fund.
- Mutual funds often also have an additional sales charge for buying or selling shares called a “load.” ETFs may have expense ratios, but they don’t have loads or transaction fees.
In addition to trading costs, there are differences in liquidity between ETFs and mutual funds. Liquidity means that you can buy and sell without affecting the market price. If you’re trading actively – making many trades throughout the year – then choosing an ETF over a mutual fund will likely save you money.
As a general rule, ETFs exhibit lower portfolio turnover than mutual funds, which means they buy and sell securities less frequently. Portfolio turnover is essential for tax-sensitive investors because capital gains distributions may be triggered when holdings are sold within a fund.
When you should consider a mutual fund
The primary reason for considering index funds over index ETFs is if you are looking for a fund to beat the market or investing in a less efficient market. In these situations, the skilled management of an actively-managed fund may be more valuable than the cost savings associated with ETFs.
Other reasons to consider a mutual fund over an ETF include if similar ETFs are thinly traded, it may be cheaper to purchase shares of a mutual fund instead of multiple small orders of an ETF.
If you want to purchase mutual funds from several different fund companies, you won’t be able to do this easily with ETFs. Mutual funds can provide access to different asset classes that are not available in any other investment vehicle, including fixed income, precious metals, options, and futures.
What is the difference between an ETF and a mutual fund?
The main difference between the two is liquidity. ETFs can be traded throughout the trading day and offers more liquidity than mutual funds that do not have intraday trades.
Are ETFs suitable for beginners?
ETFs are an excellent place for short-term investors just starting their journey due to the low expense ratios and high liquidity options available.
Are ETFs as safe as mutual funds?
Neither is considered safer than the other. Instead, the risk depends on the exposure the investor is picking in the stocks and underlying securities.