ETF vs Mutual Fund - What's the difference?
Two of the safest and most eye-catching investment options available right now are Mutual Funds and Exchange Traded Funds (ETFs) because they offer people a diverse range of stocks/bonds to purchase with the added benefit of having relatively low–very low–risk.
Mutual funds vs ETFs. Which one is better and why? The answer is partly a matter of taste and partly a matter of fact. They are very similar in several important ways, but they are also quite different. So, because mutual funds and ETFs are in vogue right now, understanding them better will serve you well. Your portfolio will thank you.
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ETFs vs Mutual Funds Overview
To grasp the mutual fund vs ETF debate, we need to define these investments and walk through the implications of choosing one over the other. First, let’s be clear: you can’t make a wrong choice. Deciding to invest in mutual funds instead of ETFs, or the other way around, won’t ruin you financially. So, shake the pressure off. You won’t be making a mistake either way. Investing is a good idea, and both mutual funds and ETFs are reliable products.
Now, the devil is in the details, so let’s get into it.
Mutual funds and ETFs are like the goodie bags of candy you used to get at your friend’s birthday party when you were a kid. They are collections of stocks or bonds or both that are strategically grouped to form a grab-bag that investors can buy. Instead of going to the store and picking individual 5-cent candies to buy, that’s the stock market, mutual funds and ETFs are the pre-made goodie bags you can buy which are filled with all sorts of different candies. The choice is done for you.
That’s the benefit of mutual funds and ETFs, you don’t have to worry about picking the best stocks to invest in. You can choose from among many different collections of stocks/bonds based on which “candies” are inside.
There are thousands of mutual funds and ETFs available. You can pick some that are centered around a particular industry or commodity, like oil or gold. You can pick others that contain some of the best-performing stocks on the market, such as the ever-popular Standard and Poor’s 500 (S&P 500).
You invest in mutual funds and ETFs by buying shares of the fund, not particular stocks inside the fund. Then the fund’s value goes up and down based on the behavior of the stock market, the buying/selling activity of the people invested in the fund, and, if it’s a fund managed by a person, how that person buys and sells shares of the stocks inside the fund.
That’s how mutual funds and ETFs are similar, now let’s explore how they are different.
What are ETFs?
An exchange-traded fund (ETF) is an investment product that tracks the performance of a group of stocks, an index, which determines whether it rises or falls in price. If most of the stocks in the ETF perform well during the day’s trading, the ETF price goes up. If most of the stocks in the ETF perform poorly, the ETF price does down.
It’s important to know that an ETF is traded just like any stock, meaning its price fluctuates based on what’s happening in the market. An ETF can be purchased at any point when the market is open for its price at that moment. You don’t have to wait until the trading day is over and the price may be significantly higher.
Most ETFs are not managed by a person, instead, they are passively managed. The index goes up and down in price and values the same way a stock does with no fund manager adjusting the ETF at all. However, there are some ETFs available now that are actively managed by a person, but the majority of ETFs are considered passive.
An ETF is great for someone who plans to take an active role in their investment. If you want access to more complicated orders than just buying, holding, and selling, then an ETF may be suitable for you.
Do you only have a little money available to invest? Then an ETF is perfect. You don’t need to meet a minimum investment limit as you do with a mutual fund. All you have to do is purchase one share or even a fraction of a share, some ETFs are available in smaller share divisions further reducing barriers to low-budget investors.
Regarding taxes, ETFs are a great option because they limit the capital gains of the investors. The nature of an ETF keeps second-hand gains low or non-existent. The sale of one position does not automatically cause all other investors to realize a capital gain that would affect their taxes. They are also considered tax-efficient investments because people who invest in ETFs usually hang on to them for a long time, allowing the index to grow organically.
What are Mutual Funds?
A mutual fund is the older sister of the ETF, the OG. Mutual funds have been around for nearly a century, the first one ever created, Massachusetts’s Investor’s Trust, was set up in 1924.
In Canada alone, there are over 5,000 mutual funds available to investors, and there’s a good reason why these investment options have stuck around so long and are so popular now: they require little to no effort on the investor’s part at all and they offer immediate diversification.
That’s because mutual funds are usually actively managed by people called fund managers. These managers handle the trading of the stocks and bonds within the mutual fund – remember that mutual funds and ETFs are both grab bags of different stocks and securities.
A mutual fund is bought and sold differently than an individual stock, however. All purchases and sales of the mutual fund take place at the end of the trading day, not during it. Everyone buys and sells shares of the mutual fund at the same price.
Most mutual funds require a minimum purchase amount from investors hoping to get involved in the fund, and that minimum might be anywhere from a couple of hundred dollars up to a few thousand dollars. Many, but not all mutual funds, also have commission fees that are paid directly to the fund managers.
Mutual Funds Benefits
Mutual funds are perfect for buy-and-hold style investors, a.k.a. most investors. You can set up automatic deposits and grow your share in the mutual fund with next to no effort.
There are a ton of options for you to consider since mutual funds are one of the most popular investment options available, so it’s easy to find just the right combination of stocks, securities, bonds, etc. that appeal to you and your investment personality. And don’t forget the immediate diversification you get when you invest in a mutual fund, and a diverse portfolio is a healthy portfolio.
When you buy a mutual fund, you are also buying financial advice and expert fund management which can certainly give you peace of mind regarding your money. Some mutual funds still charge a commission fee for these services, but it’s not hard to find a fund that doesn’t charge that fee. It’s becoming more and more normal for mutual funds to either reduce or remove commission fees entirely.
Similarities & Differences of ETFS and Mutual Funds
Similarities of ETFs & Mutual Funds
ETFs and mutual funds can both be actively or passively managed
Both ETFs and mutual funds offer diversification across sectors as one of their main selling points.
They both offer a hands-off approach to investing because the picking and choosing of stocks/securities is done for you.
They are both pooled investments
Differences of ETFs & Mutual Funds
Mutual funds often have commission fees and minimum purchase amounts. Some are several thousands of dollars. ETFs usually don’t have any sort of fee, all you pay is the share price.
You can buy an ETF at any point during the trading day. Mutual funds can only be bought or sold at the end of the trading day when the price is determined.
When mutual funds are sold, it can affect all the other members in the fund and create capital gains that may appear on your taxes. ETFs do not create these capital gains for all the members when someone sells their position.
Most mutual funds are actively managed. Most ETFs are passive, based on an algorithm and not on a person’s decision.
Frequently Asked Questions
Both are very safe investments partly because they are already diversified across sectors. One reason ETFs might be considered slightly better value than a mutual fund, is mutual funds often carry minimum purchase amounts. So, before you do any investing, you’ve already had to put up a mint just to access the fund. ETFs rarely have minimums.
A person might prefer an ETF over a mutual fund if they want to place more complicated order types instead of just buying into the ETF and holding. Most ETFs are passively managed by an algorithm instead of a human being. It might seem counter intuitive, but most actively managed funds did not, repeat did not, outperform indexes on the stock market. Last but not least, ETFs have lower or no commission fees. Mutual funds usually do have commission fees and these can quickly eat into your profits.
Both ETFs and mutual funds are low-risk investments. Now, low-risk does not mean no-risk. However, thanks to the inherent diversification of ETFs and mutual funds, they are considered much safer than dumping all your cash into one stock hoping it will perform well.