If you’re looking to diversify your investments, chances are you’ve come across a mutual fund or ETF. Both can be great options for beginner and experienced investors as they are a great way to invest in multiple assets with one investment.
While mutual funds and ETFs look similar from afar, they have many differences you should be aware of to decide which is right for you.
What is a Mutual Fund?
A mutual fund is a basket of individual assets. They can include hundreds or even thousands of stocks and bonds in one fund. Mutual funds are actively managed by a fund manager, who has the right to buy or sell assets in the fund at any time.
The goal of mutual funds is to beat the market, so fund managers are often aggressive in their tactics to earn a profit.
Types of Mutual Funds
- Open-ended funds – Open-ended funds are mutual funds with an unlimited number of shares to sell. If demand exceeds the current number of shares, the fund manager can issue more shares. Open-ended funds are valued daily to reflect the portfolio’s daily value.
- Close-ended funds – Closed-ended funds are the opposite of open-ended funds. There is a limit to the number of shares available and once bought, there are no more opportunities for investors. Close-ended funds don’t require daily valuation.
What are the Fees?
Mutual funds often have higher fees than mutual funds because they are actively managed. Most funds have an expense ratio, which is an annual charge of a percentage of your assets under management. You may also see shareholder fees, such as load fees or commissions which cover the cost of buying and selling assets within the fund.
How are they Traded?
They trade once per day after the market closes. The price is based on the next available net asset value. The price may be different than the day before, but you won’t know the price or value until the market closes. Most values are released by 6 PM ET. Investors buy mutual funds directly from the fund – they aren’t traded on the secondary market. There is a chance the price may be higher or lower than the previous day.
Minimum Investment Requirements
Mutual funds can have rather high minimum investment requirements, but that’s not across the board. For example, most Vanguard mutual funds have a minimum investment requirement of $3,000 but the Fidelity Real Estate Income Fund has no minimum. Shop around for the fund that meets your requirements including minimum investment requirements.
Pros and Cons of Mutual Funds
Pros:
- You get an already diversified portfolio
- You can reinvest any dividends earned compounding your earnings
- They are simple and hands-off for investors
Cons:
- The load fees and expense ratios can be high if you don’t pay attention
- You can’t control the taxable events (fund managers decide when to buy and sell)
- You can’t trade throughout the stock day
What are ETFs?
ETFs are also diversified securities, but unlike mutual funds, they try to mimic the market, not beat it.
An ETF can hold multiple types of funds including stocks and bonds. They can hold securities across an entire market, such as the S&P 500 ETF or focus on one industry, such as technology.
Most ETFs are passively managed which means there are fewer commissions and less buying and selling of securities.
Types of ETFS
- Sector ETFs – These ETFs focus on a specific sector or industry, such as technology. All assets within the fund have to do with the particular industry.
- International ETFs – As the name suggests, these ETFs invest in global assets versus domestic assets.
- Dividend ETFs – These ETFs focus on companies that historically pay dividends, which you can either cash out or reinvest.
- Market-Cap Index ETFs – Invests in stocks based on their market capitalization (larger companies means higher weight).
What are the Fees?
ETFs are typically less expensive than mutual funds because they are passively managed. On average, ETFs charge 0.03% of assets under management annually or $0.30 for every $1,000 invested.
Each broker charges different fees, though, so always read the fine print and know what it will cost you.
How are they Traded?
Here’s where mutual funds and ETFs really differ. You can trade ETFs all day long when the market is open, just like stocks.
ETFs have price increases and decreases throughout the day, which can make them a lot easier and more exciting to trade than mutual funds.
Pros and Cons of ETFs
Pros:
- Low commissions because they are passively managed
- Automatically diversifies your portfolio
- Liquid investment because you can buy and sell at any time
Cons:
- ETFs focused on one industry limit your diversification
- Actively managed ETFs can have higher expense ratios
- You have little control over what investments the fund accepts
How to Choose Mutual Funds vs ETFs
Each investor has different techniques and reasons for choosing mutual funds vs ETFs or vice versa.
Here’s What To Consider:
- Do you want to trade actively? If so, an ETF is the best option because you can trade them throughout the day.
- Do you want to focus on a particular industry or sector? If yes, ETFs provide a more niche product than mutual funds.
- Is tax efficiency a concern? If so, focus on ETFs where you can buy and sell at your discretion versus mutual funds which are actively managed by a fund manager giving you little control.
Final Thoughts
The right portfolio for you is the one that’s diversified and focuses on what you believe in or want to focus on.
There is no right or wrong way to invest and mutual funds aren’t better than ETFs or vice versa. Look at the big picture, determine your goals, and look closely at the tax consequences of each option to decide which is right for you.
