Most people have heard the terms “mutual fund” and “ETFs.” Even though these are common investment choices for many investors, they can still be mixed up and often investors are left wondering the difference. In the blog, we will talk about the differences and similarities between mutual funds and ETFs.
What are mutual funds?
Mutual funds are a professionally managed portfolio of stocks, bonds, or other securities. When you purchase a mutual fund, you are getting a diversified “bucket” of stocks or bonds with a fund manager to manage the mutual fund.
What is an ETF?
Similar to a mutual fund, an ETF is a diversified bundle of stocks or bonds. An ETF generally tracks a specific index. There is no professional fund manager within an ETF.
Key Differences Between Mutual Funds and ETFs:
- Active Management
One key difference in an ETF and a mutual fund is that mutual funds typically have a professional manager and ETFs typically do not. The goal of a mutual fund manager is to build an optimal portfolio rather than simply track an index. They are trying to outperform “the market” rather than simply match it. However, some ETFs funds are actively managed and some Mutual Funds are passively managed.
With a mutual fund, there is a manager between you and the trades happening. With an ETF, you are directly trading the fund yourself on the exchange, which eliminates the need for too many hands in the investment pot. While there is still management happening within the ETF, they are much more hands-off when it comes to actual trading.
Mutual Funds often have higher fees and different fees than an ETF. Because they are often actively managed, mutual funds will have fees associated with them that ETFs don’t. The fees vary widely, and it is important to know what you are paying and why when choosing an investment.
Fees are typically lower for ETFs even when comparing actively managed ETFs to actively managed mutual funds and passively managed ETFs to passively managed mutual funds.
In addition to management fees, some mutual funds assess penalties if you sell your shares too soon after you bought them (often 90 days or less). ETFs do not have this penalty and can be traded as often as you wish.
3. Timing of the trade orders
ETFs trade anytime during the trading day, they are traded on the exchange just like individual stocks. Mutual funds trade one time per day at the close of the trading day.
This means if you own a mutual fund and you click the button to sell some or all of your holdings, or you want to buy into one and you place a buy order, that trade order will sit and wait until the trading day has ended.
They will then execute the order at whatever price the fund is trading at the end of the day, which may be different from the price when you requested the trade. ETF orders can be executed at any time during the trading day, so there is more control over the price at which you choose to sell or buy.
4. Tax Efficiency
ETFs are more tax-efficient than mutual funds. This has to do with the number of trades happening within the fund itself. Even if you buy and hold your mutual fund, the manager is still making trades within that fund (they are trying to beat the market, so they will sell gains to purchase other shares and try to grow the fund) and you will have to pay taxes on any realized gains even if you don’t actually sell any of the fund.
ETFs are simply trying to track an index so there is significantly less trading happening within an ETF.
Unless your fund is held within a tax-favored vehicle like a 401(k) or IRA, you will pay yearly taxes on any gains made on trades that happen within your funds.
Key Similarities Between Mutual Funds and ETFs
Both mutual funds and ETFs must adhere to the same regulations concerning what they can own, how much can be concentrated in one or a few holdings, how much money they can borrow in relation to the portfolio size, and more.
Both mutual funds and ETFs offer diversification within each fund. Most ETFs and mutual funds hold between 100 and 3,000 different securities within one fund.
You can choose different sectors, such as large US, small US, international, emerging markets, bonds etc. with both mutual funds and ETFs. This means with a few simple fund choices, your portfolio could be invested in most of the major asset classes available.
3. Ease and overall cost of investing
Due to the instant diversification within these two investment vehicles, it is much easier to build a portfolio of Mutual Funds or ETFs than to try and build your own diversified portfolio of individual stocks.
It is also much cheaper to use one of these than to purchase individual stocks, since individual stocks can be pricey. While mutual funds tend to have higher costs than ETFs, they are still cheaper than trying to purchase hundreds or thousands of individual stocks on your own. It is also much less stressful since you don’t have to manage the shares yourself.
Which is better ETF or mutual fund?
This depends. While there are many advantages to investing in ETFs, there are some reasons investors choose mutual funds. Niche investing is one small example of this. Also, mutual funds have been around for much longer than ETFs. Many investors choose to keep their mutual funds because selling them would create a large taxable event.
Common ETF vs. Mutual Fund Questions:
- Why buy an ETF instead of a mutual fund?
While there are pros and cons to both mutual funds and ETFs, ETFs have many benefits. If an investor’s goal is to buy and hold in a low-cost and tax-efficient way, an ETF might be the way to go. This is not always the case though, so we recommend you speak to your financial planner to find out what is best for you.
- Are ETFs riskier than mutual funds?
When investing, risk comes in many forms. A stock ETF is riskier than a bond mutual fund simply because it is invested in stocks, not because it is an ETF. When comparing apple to apples though (like an S&P 500 ETF next to an S&P 500 mutual fund), ETFs are no riskier than mutual funds. Both are less risky than individual stock investing.
- Should I have both ETFs and mutual funds?
Having a portfolio of both mutual funds and ETFs could be beneficial depending on the reasons behind the choices. Just having both for the sake of having both won’t make a big difference. But if you want to track certain indexes in a low-cost and tax-efficient manner, you could choose ETFs for that goal. Then maybe you want to expose your portfolio to a specific niche market, and you may need a mutual fund to effectively do that.
- Why are ETFs cheaper than mutual funds?
In general, ETFs are cheaper than mutual funds because there isn’t a middleman involved in purchasing shares on your behalf. When you purchase an ETF, you purchase it directly on the exchange as you would an individual stock. With a mutual fund, you are buying into that fund and the manager will purchase and sell shares within the fund itself. There are more steps involved and more hands in the process for mutual funds, making them cost more to run.
Invest in mutual funds or ETFs today!
The choice of how to invest is highly individualized and there is no one-size fits all approach. If you would like to discuss your portfolio and what makes the most sense for you and your situation, feel free to schedule a free discovery call with one of our financial advisors today.
Kayla Welte, AFC®, ChFC®, CFP®, has been helping clients maximize their finances since 2009. With a background in financial education & counseling, Kayla is passionate about helping people prioritize & reach their financial goals. Kayla is a Financial Planner at District Capital Management, a financial planning firm designed to help professionals in their 30s & 40s elevate their finances. Schedule a free discovery call.