Exchange-traded funds (ETFs) and mutual funds are both popular investment options for retail investors, but they have some key differences. ETFs and mutual funds allow investors to diversify their portfolios by holding a basket of different stocks, bonds, or other securities. However, the way they are managed, traded, and taxed can differ significantly. In this article, we will discuss the pros and cons of ETFs and mutual funds, as well as the key differences between the two.
What is Mutual Fund
A mutual fund is a type of investment vehicle that pools money from multiple investors to purchase a diversified portfolio of securities, such as stocks, bonds, or real estate. The fund is managed by a professional fund manager who makes investment decisions on behalf of the investors. Mutual funds are typically bought and sold at the end of the trading day at their net asset value (NAV), which is the value of the fund’s assets minus its liabilities divided by the number of shares outstanding.
Mutual Fund Pros and Cons
- Diversification: Mutual funds allow investors to hold a basket of different securities, which can help to reduce risk.
- Professional management: Mutual funds are managed by professional fund managers who make investment decisions on behalf of the investors.
- Liquidity: Mutual funds are typically easy to buy and sell, and investors can get their money out of the fund on any business day.
- High fees: Mutual funds often have high expense ratios, which can eat into returns over time.
- Lack of control: Investors have little control over the specific securities that are held in the fund.
- Timing of NAV: Mutual funds are bought and sold at the end of the trading day at the NAV, which can be disadvantageous if the market is moving quickly.
What is ETF
An ETF is similar to a mutual fund but is traded on an exchange like a stock. ETFs also hold a basket of securities, but unlike mutual funds, ETFs can be bought and sold throughout the trading day at market prices. ETFs are also managed differently, with the fund issuer creating or redeeming shares based on demand from authorized participants, rather than by fund managers buying and selling underlying securities.
ETF Pros and Cons
- Diversification: ETFs also allow investors to hold a basket of different securities, which can help to reduce risk.
- Low costs: ETFs often have lower expense ratios than mutual funds.
- Intraday trading: ETFs can be bought and sold throughout the trading day, which can be beneficial in fast-moving markets.
- Lack of control: Investors have little control over the specific securities that are held in the ETF.
- Premium/Discount: ETFs can trade at a premium or discount to their NAV, which can be disadvantageous for investors.
- Limited fund options: ETFs are not available for all types of securities or sectors.
Differences between the two
How are they managed?
Mutual funds are managed by professional fund managers who make investment decisions on behalf of the investors. While they can be actively or passively managed, most mutual funds are actively managed.
ETFs, on the other hand, are managed differently. The fund issuer creates or redeem shares based on demand from authorized participants. While they can also be actively or passively managed, most ETFs are passive investments pegged to the performance of a particular index. This means that the fund’s holdings are designed to mirror the performance of a specific index, such as the S&P 500 or the NASDAQ 100. This approach aims to reduce management costs and provide returns that are similar to the index being tracked.
How are they traded?
Mutual funds are typically bought and sold at the end of the trading day. ETF like stocks are bought and sold throughout the trading day on a stock exchange.
When it comes to minimum investment, ETFs and mutual funds are quite different. ETFs are similar to stocks and can be purchased for the price of one share, making it accessible for small investors. You don’t need to have a minimum amount of money to start investing in ETFs.
On the other hand, mutual funds require a minimum investment which is usually a flat dollar amount, this means you need to have a certain amount of money to start investing. However, mutual funds can be purchased in fractional shares or fixed dollar amounts which make them accessible to investors with smaller amounts of capital. Minimum investment for mutual funds can vary, some have a minimum investment as low as $100, while others require a minimum investment of $1,000 or more.
ETFs and mutual funds have different costs associated with them. ETFs have both explicit and implicit costs. The explicit costs include trading commissions, which are charged by the broker, and the operating expense ratio, which is disclosed by the ETF provider. The implicit costs include the bid/ask spread and premium/discount to NAV, which are costs that result from buying or selling an ETF in the market at a price that may differ from the value of the ETF’s underlying holdings. These implicit costs can be difficult to quantify and may vary depending on the ETF and the market conditions.
On the other hand, mutual funds have explicit costs such as operating expenses and they may also carry other fees such as sales loads or early redemption fees. These fees can have a significant impact on returns over time.
Mutual funds can be less tax-efficient than ETFs because they are required to distribute capital gains to shareholders annually, even if the shareholder did not sell their shares. This can result in a tax liability for the shareholder. ETFs, on the other hand, can be more tax-efficient because they can be bought and sold without triggering a capital gain. Additionally, ETFs can also be more tax-efficient because they can be traded in a tax-deferred account like a 401(k) or IRA.
Which is better?
The decision of whether to invest in ETFs or mutual funds will depend on an individual’s investment goals, risk tolerance, and investment horizon. Both types of investment vehicles can be suitable for different investors. ETFs may be more suitable for short-term or active traders, while mutual funds may be more suitable for long-term investors who prefer a more passive approach. It is important for investors to do their own research and consult a financial advisor before making a decision.