What Are The Differences Between ETFs and Mutual Funds?
An investor who is debating ETFs vs. mutual funds will see many similarities and a handful of key differences between these two types of investments. For example, ETFs and mutual funds both give investors the opportunity to invest in a group of stocks, which insulates investors from events that can cause wild price variations in a single debt or equity instrument.
The differences between ETFs and mutual funds are typically the catalyst that drives an investor’s purchase decisions.
- Flexibility. ETFs are perceived as being more flexible than mutual funds because they can be actively bought and sold at a known price throughout the day, while the exchange market is open. By contrast, mutual funds that are bought and sold after markets are closed at the end of the day.
- Transparency. Investors have full and complete information on the assets that are held in an ETF on a daily basis. Actively-managed mutual funds disclose their holdings only quarterly or semi-annually.
- Tax Efficiency. ETFs are traded among investors with no need for the fund to sell holdings when ETF shares are sold. Accordingly, ETFs have fewer taxable events relating to dividends, which lowers an ETF investor’s overall tax liabilities.
- Minimum Investments, Fees & Commissions. Investors can invest in ETFs with lower initial amounts. Because ETFs are typically not actively managed and do not have large marketing expenses, they typically impose a lower fee structure on investors. Trading commissions may be higher for ETF purchases and sales than for mutual funds.
Should I Invest in ETFS or Mutual Funds?
- You may want to invest in ETFs if:
- You pride yourself in being on the cutting edge. The first ETF was released in January 1993, so they’re considered “the new kid on the block,” versus the old dinosaur “mutual fund,” which has been available since March 1924.
- You’re just getting started. ETFs offer a low barrier to entry, which is exciting if you’re just starting out with your investment portfolio. You can buy an ETF for as low as $50, while mutual funds require a minimum initial investment, which is usually in the $1,000 – $3,000 range. Investing, say, $100 in a stock ETF and $100 in a bond ETF gives you a diversified, dual-asset-class portfolio without costing much.
- You thrive on the excitement of active trading. ETFs allow you the flexibility of intraday trades, short sales, stop orders, and limit orders that you can’t do with mutual funds. In that way, ETFs give you more control over prices in the moment. You can be as bullish or bearish as you’d like.
- Certain niches appeal to you. If you want to invest more heavily in specific industries or commodities, you can do gain market niche exposure with an ETF or actively-managed mutual fund, but not with index mutual funds.
- You’re tax sensitive. ETFs are the most tax efficient investment because they do not distribute a lot of capital gains. Index mutual funds are the second-best option at tax-time – better than actively managed mutual funds.
- You’re tactical. In short, ETF investors are interested in short-term repositioning of their portfolios. Tactical investing can be riskier with additional upfront costs, but you can take advantage of sector surges, attractive interest rates, and market fluctuations to suit your needs.
- You want aggressive growth. ETFs represent some of the more interesting funds out there. You can invest in thematic funds based on current market trends and exotic ETF strategies that squeeze potential before it’s popular. Drones, retail, health and fitness, and gold exploration are niches that have shown explosive growth in recent years.
You may want to invest in mutual funds if:
- You feel more comfortable with the old vanguard. Mutual funds are the most popular type of investment for a reason. They’re viewed as more stable and reliable – lower in risk, compared to ETFs. For this reason, most workplace retirement plans like 401Ks offer mutual fund investments, rather than ETFs. You can opt for an automatic investment plan outside of your employment as well – or take advantage of Dividend Reinvestment Plans (DRIPs) that automatically convert dividend distributions into investment growth.
- You are looking for a passive, low-cost way to invest. Index mutual funds mirror an index and have annual expenses less than 0.10%. If you want more flexibility and diversity, you can add actively managed funds into the mix, too.
- You are a periodic investor. If you make monthly or quarterly IRA deposits or manage your risk by investing fixed sums of money at regular intervals, a no-load mutual fund would be more cost-effective than an ETF, which incurs a trading commission every time you make a periodic investment. Many people prefer to grow investments gradually over time and see how products perform before fully committing. With a dollar-cost averaging strategy, where you invest a set amount each month, you will end up paying less per share over time by purchasing more shares in months where share price is low.
- You are looking for a fund that could potentially beat the market. Actively managed mutual funds can beat benchmark projections, although it is difficult to achieve this end consistently.
- You are a young investor with stable income. With many years of investing ahead of you, a mutual fund like an equity fund could help you achieve greater returns.
- You are a midcareer investor looking to balance risk and return. A balanced mutual fund with a mix of stocks and bonds could help you achieve your financial goals.
- You are approaching retirement. Easy living is ahead of you, but you may want to put your riskier days behind you and focus on modest fixed income investments (like bond funds) that will comfortably see you through your Golden years.
- You are more conservative in your risk tolerance. ETFs can be fickle – just as volatile as they can be lucrative. Some ETFs are thinly traded, with wide bid/ask spreads. The price you pay for your ETF shares may be much less than the underlying value, particularly if the ETF doesn’t see a lot of trading activity. Mutual funds, on the other hand, always trade at Net Asset Value without bid/ask spreads. With passive and actively managed mutual funds, you can find all possible combinations of security and risk. Most investors will go with mutual funds in tried-and-true growth stocks, but also seek a few opportunities from up-and-coming businesses that could translate to explosive growth as well.
Few investors can be pigeon-holed into one particular investment strategy or goal, so why not both? There is no reason you cannot diversify your portfolio by using both ETFs and mutual funds. These two siblings share many features, but their subtle differences could make your profile so much more robust.
- thebalance.com: The History of ETFs. https://www.thebalance.com/the-history-of-etfs-1214784
- thefool.com: ETFs vs. Mutual Funds: The Pros and Cons. https://www.fool.com/investing/etf/2018/01/15/etf-vs-mutual-funds-the-pros-and-cons.aspx
- schwab.com: ETF vs. Mutual Fund: It Depends on Your Strategy. https://www.schwab.com/resource-center/insights/content/etf-vs-mutual-fund-it-depends-on-your-strategy
- Finance Industry Regulatory Authority: ETF vs. Mutual Fund Difference. http://www.finra.org/investors/highlights/etf-vs-mutual-fund-difference
- Schwab: Investing Tactically with ETFs. https://www.schwab.com/active-trader/insights/content/investing-tactically-with-etfs
- US News & World Report – 10 ETFs to Buy for Aggressive Growth, https://money.usnews.com/investing/slideshows/10-etfs-to-buy-for-aggressive-growth
- Ontario Securities Commission – 4 Reasons to Buy Mutual Funds, https://www.getsmarteraboutmoney.ca/invest/investment-products/mutual-funds-segregated-funds/4-reasons-to-buy-mutual-funds/
- MutualFunds.com – Why You Need Mutual Funds in Your Portfolio Even if You Own ETFs, http://mutualfunds.com/education/why-you-need-mutual-funds-in-your-portfolio-even-if-you-own-etfs/
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