What is the difference between a mutual fund and exchange-traded funds (ETFs)?
Deciding on whether you want to buy a mutual fund or an exchange-traded fund (ETF) can seem like an unimportant concern, but there are some key differences between these two funds and not knowing the distinctions between the two can affect your profits.
Some investors focus more on choosing between stocks or bonds, domestic vs. foreign, value, and growth but knowing the difference between a mutual fund and an ETF can help you understand how to turn your investment into an advantage. Being knowledgeable of how the two differentiate from one another can also have an impact on the outcome of your investment in the long run as well.
Similarities Between a Mutual Fund and an ETF
Both a mutual fund and an ETF hold portfolios of stocks or bonds and from time to time something a bit more exotic like commodities or precious metals. They must obey the same regulations which cover exactly what they can own, how much can be concentrated in one or a few holdings, how much money can be borrowed in relation to the size of the portfolio, and so on.
Besides these elements, the paths of the two deviate. Some of the distinctions may seem vague and shaky, but they can make one of the two funds fit your needs more than the other.
Difference Between a Mutual Fund and an ETF
When placing money into a mutual fund, the business deal is with the company that manages it directly or through a brokerage firm. You purchase at the net asset value of the fund based upon its price when the market closes that day or the next day if your order is placed after the markets close.
When you decide to sell your shares, it’s the same process only in reverse. Sounds appealing? Well, you shouldn’t rush into it because some mutual funds assess a penalty. If you sell sooner than 90 days after purchasing it, the penalty is 1% of the shares’ value for selling too early.
Just as the name suggests, ETFs trade on exchanges, so ETF investors don’t really have to face that prospect. Meaning that just like with common stocks, the other side of the trade is another investor just like you and not the fund manager. You can choose to buy and sell at any point during a trading session at the existing price according to market conditions and not just at the end of the day where there is no minimum holding period. This will be relevant in a case where the ETFs are tracking international assets where the price of the asset has not been updated to show new data and the US market’s estimate has been updated. ETFs can reflect the new market reality a bit faster than mutual funds are able to.
Another important difference is that with most ETFs there is index-tracking, which means trying to match the returns and price movements of an index. Mutual funds can also track indexes, but they are mostly actively managed which means the people who run them pick holdings and try to beat the index that they’re judging performance against. Actively managed funds have to spend money on analysts, economic and industry research, visiting companies, and more. These obligations can become expensive which can make mutual funds more expensive to manage than ETFs.
Things to Consider
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, so it’s important to include the tax costs when making a decision to move over to an ETF.
Your decision will ultimately boil down to comparing the long-term benefit of switching to a more profitable and secure investment and paying more taxes upfront as opposed to staying with a portfolio of less ideal investments and higher expenses.
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. Mutual funds often make more sense when investing in obscure niches, like stocks of smaller foreign companies and multifaceted yet potentially worthwhile areas like market-neutral or long/short equity funds that feature obscure risk/reward profiles.
However, in most circumstances and mostly for investors who wish to keep things as easy as possible, ETFs, with their combination of low costs, ease of access, and emphasis on index tracking may be favored. Their capacity to deliver exposure to a variety of market segments in a direct way makes them valuable tools if your precedence lies in accumulating long-term wealth with a balanced, extensive portfolio.