You might be amazed by the number of similarities between an ETF and a mutual fund. Both these funds pool investors' money into different asset categories, can be used to build a diversified portfolio and support a variety of investment strategies. The questions then are, how do you choose between an ETF and a mutual fund, which is better and when?
When you're just starting out as a trader or as an investor, there are so many terms, acronyms and principles to get familiar with that, for some, it might feel overwhelming. When you find the answer to a question, it might just raise a couple of more questions. Such a frequently asked question among young and novice stock investors is related to the difference between an ETF and a mutual fund.
In the perpetually changing world of investments, ETFs and mutual funds stand as two of the most popular investments options for those striving for diversification and growth potential. However, these investment vehicles are different in terms of strategy, the way that can be traded, the fees and available liquidity. By understanding the subtle differences between ETFs and mutual funds, you may be able to understand which of these options suits better to you.
ETF vs Mutual Fund – Key Takeaways
- Both ETFs and mutual funds have become increasingly popular investment option during the recent years due to their versatility and diversification characteristics.
- ETFs are tradeable throughout the day on exchanges offering greater flexibility, while mutual funds transactions can only occur at that end-of-day price, which reflects the Net Asset Value (NAV).
- Both ETFs and mutual funds can be managed actively or passively. However, ETFs are often passively managed, whereas mutual funds are typically actively managed.
- In general, passively managed funds have lower expense ratios than actively managed ones, which is why ETFs are often considered as more cost-efficient than mutual funds.
Understanding ETFs vs Mutual Funds – Overview
Before we compare mutual funds and ETFs, it's essential to understand how these two key investment vehicles work.
ETFs
Mutual Funds
ETFs (Exchange-Traded Funds) are investment vehicles that are traded on stock exchanges. This type of fund usually follows a commodity (like gold), or an index, like the S&P Index. ETFs are exchange-traded products that can be bought and sold throughout the day, unlike traditional mutual funds. Because ETFs provide the benefits of diversification at a cheaper cost than traditional mutual funds, they became more and more popular among investors.
An investor can purchase an exchange-traded fund (ETF) that tracks the S&P 500 index, for instance, if they wish to buy the index. This would mean that instead of buying each stock separately, the investor would own a little portion of each of the 500 companies in the index.Mutual funds are investment vehicles that enable investors to pool their funds and make investments in a variety of securities, including stocks, bonds, and other assets. Professional money managers that oversee active mutual funds carefully choose the underlying securities in the fund's portfolio with the purpose of maximizing return on investment.
Investors can profit from mutual funds in several ways, including liquidity, competent management and diversification. Mutual funds do, however, have some risks, including fees and market risk. Mutual funds can be a solid choice for investors trying to expand their investment portfolio without taking an active approach to managing their assets.
In a nutshell, ETFs and mutual funds are collections of assets packaged into a single financial product. Both fund types use investor money to purchase securities within the fund portfolio.
ETF vs Mutual Fund - Similarities
Mutual funds and exchange-traded funds (ETFs) share several structural characteristics, the most notable being that they are both collections of individual securities, like stocks or bonds. When funds from many asset classes are combined, they can be utilized to form a well-rounded portfolio, offering more diversity than investing in a single stock or bond. Both provide access to a wide range of asset classes and niche markets.
- Diversified structure: Both fund types consist of a basket of securities purchased with money pooled from individual market participants.
- Pro Management: ETFs and mutual funds are managed by professional managers or management organizations. Both ETFs and mutual funds can be actively or passively managed. However, most ETFs are passively managed to match an index.
- Wide range of assets: Both offer investors access to a wide range of asset classes, including stocks, bonds, commodities, cash-equivalent securities, or a mix of these.
- Performance evaluation: ETFs, like mutual funds, compute their net asset value (NAV) at the end of the day. Both get their value from the underlying assets they invest in, and the net asset value is determined in the same way. In both circumstances, the rise and decline in terms of NAV value reflects mutual fund’s/ETF’s performance.
Mutual Fund vs ETF - Differences
In terms of investments, ETFs and mutual funds stand as two titans, offering different and appealing potential benefits. ETFs and mutual funds have similarities but many differences as well.
Differences between ETF and Mutual Fund
ETFs
Mutual Funds
Trading
An ETF unit can be actively bought and traded on exchanges, much like individual stocks A mutual fund unit can be purchased directly from the fund house or through authorized intermediaries.
LiquidityETF units are available for purchase and sale at the price in effect at any time during sessions' hours. Mutual funds are only priced at the fund administrator's determined net asset value (NAV) once every day.
ManagementMost ETFs are passively managed. Mutual funds can have both an active or a passive management, depending on their type and structure. Mutual funds that are passively managed include index funds and funds of funds (FoFs).
CostsETFs tend to have lower fund expense ratios as compared to mutual funds. An actively managed mutual fund could have a higher total expense ratio. In general, the lower the expense ratio, the better.
Minimum investmentsUsually, the minimum amount necessary to purchase an ETF is the price of one share, usually referred to as the ETF's "market price." Mutual funds' minimum starting investments are often set as a flat dollar amount and aren't determined by the share price of the fund.
Holdings transparencyETFs disclose their holdings every trading session. Mutual funds submit a quarterly report detailing their holdings, fees, and other important details.
How Mutual Funds & ETFs Generate Returns for Their Investors
There are three ways how investors might profit from their investments in ETFs and mutual funds:
- Dividend Payments: A mutual fund or exchange-traded fund (ETF) may generate income in the form of dividends on the assets in its portfolio, based on the underlying securities they hold. Subsequently, the mutual fund or the ETF distributes almost all the income to its investors (less declared costs) that it has achieved.
- Capital Gains Distributions: An ETF or mutual fund's holdings might experience an increase in price over time, known as capital gain. Most mutual funds and ETFs provide their shareholders with a distribution of these capital gains (less any capital losses) at the end of the year. ETFs aim to reduce these capital gains, by exchanging in-kind with redeeming authorized participants rather than selling portfolio securities.
- Increased NAV/Increased Market Price: The net asset value of a mutual fund and its shares rises when the market value of the fund's portfolio rises following the liabilities and expenses deduction. If the ETF's net asset value rises, this may also result in an increase in the market price of its shares.
Mutual funds typically give investors two options when it comes to capital gains and dividend payments: either the investor receives a check or another kind of payment from the mutual fund, or the investor can choose to have the dividends or distributions reinvested in the mutual fund to purchase more shares (often without having to pay an additional sales load). In contrast, an investor in an exchange-traded fund (ETF) may have to pay more brokerage costs and face more difficulty if they choose to reinvest a dividend payment or capital gains payout.
How do they do that?
Both mutual funds and exchange-traded funds (ETFs) have underlying assets that are managed by professionals. Nevertheless, based on the fund's strategy, their degree of engagement with those underlying assets' daily fluctuations are different.
Passive Strategies
Active Strategies
Passive strategies are usually created to replicate the performance of indexes, like the BET Index that provides exposure to some of the best Romanian stocks. After being developed, these techniques require relatively minimal involvement from fund managers. All that passive funds do is swap out their assets for bonds or equities from the index-listed firms. These strategies prioritize tax efficiency since they necessitate fewer purchases and sales of the fund's underlying securities. These strategies, which are directly the outcome of the research and experience of the investment experts overseeing them, usually aim to provide higher returns by identifying opportunities to buy low and sell high. Fund managers must use a hands-on approach to choose these investments with the goal of exceeding a benchmark index. They must accomplish this by finding opportunities in the market, all while staying within the parameters of a predetermined investment strategy, such as long-term growth or medium-term income.
ETFs vs Mutual Funds Pros and Cons
Regarding which kind of fund offers a better potential for overall performance when comparing ETFs to typical open-end mutual funds, there is no clear winner because each has advantages and disadvantages based on the underlying assets.
However, exchange-traded funds frequently provide more advantages than conventional open-end mutual funds when one considers elements like cost effectiveness and tax savings potential—two crucial criteria when selecting any investment.
ETFs
Mutual Funds
Pros Cons Pros Cons Liquidity: Easy to trade throughout the whole session.
Higher market impact: In turbulent market conditions, the price at which of an ETF trades can deviate significantly from its net asset value (NAV) Flexibility: mutual funds with active management can faster be adjusted to opportunities and changes in the market. Limited trading freedom: You can only trade at the NAV once every day.
Lower costs: Typically, lower expense ratios Low customization options: An ETF's holdings are only defined by the index it tracks. Professional management: actively managed mutual funds provide opportunities for better earnings Higher costs: Expense ratios can be higher and sales charges Transparency: Holdings are usually disclosed daily. Passive management: ETFs that track an index cannot outperform the benchmark. Convenience: mutual funds allow you automatically reinvest dividends and capital gains distributions. Required investments: Frequently demand a sizeable initial investment
Finally, both ETFs and mutual funds have advantages and disadvantages and the best option for you will probably ultimately be determined by your investment objectives.
Investing in ETFs vs Mutual Funds: Which is Better?
If you are unable to choose between mutual funds and exchange-traded funds (ETFs), you may not have discovered yet what kind of investor you are.
Either of these solutions can be a good option if you are interested in building a diversified investing portfolio. However, depending on the time horizon, risk appetite, and financial goals, you may decide which one is better for you. Liquid investments are often prioritized over long-term investments by certain investors. Even though both fund types offer advantages in terms of diversification and are quite similar in nature, your investment record may benefit from a balanced and intelligent mix of mutual funds and exchange-traded funds.
To be sure you are making the best investment decision for yourself, though, set a list of priorities you have as an investor, learn how each of these funds operate, and weigh the market risks you're ready to accept.
Why Invest in ETFs?
Investors can choose exchange-traded funds (ETFs) for a variety of reasons to help them achieve their financial objectives. ETFs are very flexible because they can be bought and sold at any time of day on an exchange. This makes them especially ideal for those who like to manage their own assets.
While ETFs are a cost-effective way to get broad market exposure and diversify your portfolio, they may also be a good option for those looking to minimize capital gains taxes and investing costs. For investors who are cost-conscious and less concerned with selecting individual securities, ETFs offer more straightforward exposure to a market.
An ETF could be more suitable for you if:
- You are seeking for a passive efficient way to diversify your portfolio
- You trade or invest actively; day trading, stop and limit orders, and short selling are possible with ETFs, but not with mutual funds
- You want a lower-cost investment option and no minimum investment requirement
- You prefer investing in an asset class with full transparency in terms of holdings disclosure
Why Invest in Mutual Funds
However, there are several reasons why individuals may choose mutual funds over ETFs to achieve their investing objectives. One important factor is that, especially if you're working with an advisor, they might be easy to handle in a hands-off manner.
Additionally, mutual funds are frequently a preferable option for people who want to automatically invest a certain amount of money on regular periods, such as monthly. This approach, also known as dollar cost-averaging, is frequently used to grow wealth over time to achieve long-term goals such as saving for retirement.
A mutual fund could be more suitable for you if:
- You are a long-term investor committed to staying invested, even during challenging market conditions.
- You prefer an active professional management for your portfolio
- You are seeking an investment option with a set-it-and-forget-it automatic contribution program
- You're looking for a fund that could potentially beat the market
Bottom line
The debate between ETFs versus mutual funds has been and will be long staying within investors communities. While there are advantages to both kinds of investments, depending on the circumstances of each investor, one option may be more appropriate than the other. To choose which kind of investment is ideal for you, it is necessary to study the differences between them.
It all boils down to your core investment values. If you like the flexibility of trading intraday and prefer lower fee ratios in most circumstances, you may go with ETFs. In contrast, you may choose mutual funds if you are concerned about the impact of commissions and spreads.
Nevertheless, we need to point out that this is not a mandatory choice. Exchange-traded funds (ETFs) and mutual funds can coexist peacefully in a solid and diversified investment portfolio.
Free resources
Before you decide to trade or invest in stocks or bonds, you should consider using the educational resources we offer like CAPEX Academy or a demo trading account. CAPEX Academy has lots of free trading courses for you to choose from, and they all tackle a different financial concept or process – like the basics of analyses – to help you to become a better trader or make more-informed investment decisions.
Our demo account is a suitable place for you to get an intimate understanding of how trading and investing work – as well as what it’s like to trade with leverage – before risking real capital. For this reason, a demo account with us is a great tool for investors who are looking to make a transition to leveraged securities.
Sources:
https://www.ici.org/
https://www.sec.gov/
https://corporatefinanceinstitute.com