In the world of traditional investments, mutual funds and ETFs are two of the most common options considered. While they have several similarities, their differences can make one investment a more suitable option than the other.
What, exactly, are mutual funds and ETFs—and what do you need to know about their differences? Here’s a quick breakdown to help you make more informed decisions about your portfolio.
What Is a Mutual Fund?
A mutual fund is an investment vehicle that allows multiple investors to pool their money together to buy a diverse set of securities, including stocks and bonds. It can be used to create a well-diversified portfolio at a fraction of the cost of buying hundreds or thousands of individual stocks. Shares of a mutual fund are bought directly from fund management companies such as Fidelity, T. Rowe Price, or Vanguard.
You may purchase a mutual fund share at the end of the trading day at its net asset value. The net asset value is determined by subtracting a fund’s total liabilities from the value of its total assets.
What Is an ETF?
Similar to a mutual fund, an exchange-traded fund (ETF) is an investment vehicle pooling money from investors to purchase multiple stocks and bonds, and efficiently provide portfolio diversification. Like the buying and selling of individual stocks, ETFs are traded on an exchange.
ETFs can be bought or sold anytime during the day while the stock market is open. This means that, similar to individual stocks exchanged on the Nasdaq or New York Stock Exchange, the price of an ETF can change throughout the trading day.
How Mutual Funds and ETFs Differ
ETFs and mutual funds both begin with money pooled from multiple investors. But below are a few of the key differences between these common investment vehicles.
Management Style
There are two types of management styles: passive and active.
With active management, a professional advisor or manager uses their education and investing experience to attempt to outperform the market by actively buying and selling shares on a regular basis.
Passive management attempts to match, not outperform, long-term market benchmarks. Once the investment is selected, the manager takes a more hands-off approach, allowing the investment to ride out the day-to-day ups and downs of the market.
Because active management requires more involvement on the advisor’s behalf, the associated fees and costs tend to be higher than on a passively managed investment.
ETFs are typically managed passively, while mutual funds are about 50/50 split between active and passive management.
Pricing
As mentioned, mutual funds are traded at the end of each open trading day at a price determined by their net asset value.
However, ETFs can be bought and sold throughout the day, just like individual stocks on a stock exchange.
Since ETFs are sold throughout the day, the market dictates the value of an ETF, and it can easily change on a dime. If demand suddenly rises for a certain ETF, it may get priced higher than its net asset value. Or, if investors sell en masse, the price can drop below its value.
Expense Ratios
It’s helpful to know how much you’ll pay to invest in different vehicles. The percentage of fees and costs an investor pays to own a fund is known as the expense ratio.
Since passively managed funds typically have lower fees, ETFs are often considered less expensive than mutual funds. A typical expense ratio of ETFs is between 0.05% and 1%.
An ETF’s expense ratio includes all associated fees, such as:
Management fees: These cover all the behind-the-scenes management and technical work needed to select and manage funds.
Commission fees: Unless investing in a “commission-free ETF,” you will likely be charged a commission fee by the brokerage firm when you buy or sell shares.
Since mutual funds are typically actively managed, you can expect higher expense ratios. Along with operating and managing fees, mutual funds may be subject to sales load fees:
Front-end sales load fees: Investors pay these when the mutual fund is initially purchased.
Back-end sales load fees: Investors pay these when they’ve redeemed or sold their fund shares.
Taxes
In general, ETFs tend to give more control over tax liabilities. A mutual fund company may decide to sell shares of the securities, triggering capital gains tax for investors. You are still liable for the capital gains incurred even if you did not choose to sell your shares.
On the other hand, ETFs are traded on the exchange, which matches buyers and sellers. Lower turnover means you won’t pay capital gains on an ETF until you sell the shares and make a profit. Generally speaking, the triggers for capital gains tax on ETFs tend to be fewer and farther between than mutual funds.
Which Type of Investment Is Right for You?
You have several considerations to keep in mind when deciding if mutual funds or ETFs are the right investment vehicle for your portfolio. From costs and fees to tax implications, these can all impact the effectiveness of an investment vehicle.
Curious to know which investment vehicle may be more aligned with your goals? Our fee-only advisors would be happy to look at your current financial standings and discuss a plan for achieving your long-term goals. Feel free to reach out to our team and schedule a complimentary consultation.
This material was prepared by Kaleido Inc. from information derived from sources believed to be accurate. This information should not be construed as investment, tax or legal advice.