Mutual funds have long been a popular way to invest as they allow investors access to a wide range of investments at a low price. But since the introduction of exchange-traded funds (ETFs) into the American market in 1993, the amount of money invested in ETFs has grown rapidly. As you choose your investments for your portfolio, know the similarities and differences between a mutual fund and an ETF so you can choose what’s right for you.
How are Mutual Funds and ETFs alike?
Both mutual funds and ETFs hold portfolios of stocks, bonds, commodities, precious metals, and other investments. Mutual funds and ETFs must obey the same regulations that dictate what types of investments they can own and how concentrated they can be in their holdings. Because of these similarities, many mutual funds and ETFs offer comparable investment portfolios.
How are Mutual Funds and ETFs different?
Mutual funds and ETFs are bought and sold through different processes. Mutual funds are bought and sold only one time per day. When placing money into a mutual fund, you purchase at the net asset value of the fund based upon its price when the market closes. You buy and sell your shares directly with the fund manager, who then goes on to buy and sell the corresponding investments in the mutual fund.
ETFs, however, trade on exchanges. You can choose to buy and sell at any point during a trading session, and there is no minimum holding period. The price is set according to market conditions, so sometimes the price fluctuates above and below the net asset value of the portfolio.
With ETFs, the other side of the trade is another investor just like you and not the fund manager, just like with common stocks. This is why most ETFs have a lower expense ratio than comparable mutual funds. When the ETF changes hands from you to another investor, there’s a buyer for every seller so the ETF itself can still remain invested in all of the underlying assets. A mutual fund might need to buy and sell underlying assets at the end of the day to match up with investor demand.
Things to Consider
Both mutual funds and ETFs offer a wide range of investment strategies. Some mutual fund strategies involve passive index-tracking, which means trying to match the returns and price movements of an index. However, most mutual funds are actively managed, which means the people who run them pick holdings and try to beat their chosen index. The very first ETFs began as passive indexing strategies, and even now, very few active ETFs exist.
ETFs are fairly new, and mutual funds have been around for ages, so veteran investors are more likely to hold mutual funds over ETFs, mainly because of the built-in taxable gains that come with mutual funds. By selling those funds, you may trigger capital gains. It’s important to consider the tax costs when deciding whether or not to make the switch to an ETF.
So Which Way Should You Go?
Given the differences between the two kinds of funds, how do you decide which one is more beneficial for you? Each one can fulfill different needs so that will depend on you.
Your first concern should be deciding your investment strategy. Then, you can compare multiple mutual funds and ETFs to see which funds fit best into your investment strategy.
Mutual funds often make more sense when investing in obscure niches, like stocks of smaller foreign companies and complicated investment strategies like market-neutral or long/short equity funds that feature obscure risk/reward profiles.
However, for many investors, ETFs make investing simple with their combination of low costs, easy market access, and emphasis on index-tracking. Their capacity to deliver exposure to a variety of market segments in a direct way makes them valuable tools for accumulating long-term wealth with a balanced, diverse portfolio.