When deciding where to invest your money, you often hear the terms: stocks, ETFs, mutual funds or index funds. It can definitely be confusing trying to decipher what is what. Should I be investing in a stock or mutual fund? What’s the difference between an ETF and index fund? Which ones provide return? Which one’s have the highest fees? Today, we are going to look at the difference between an ETF and mutual funds.
What is a mutual fund?
Mutual funds have been around almost a century and are professionally managed investment funds that pool individual investor’s cash to purchase a basket of securities. Mutual funds can only be purchased at the end of the trading day on the NAV (Net Asset Value) price. The NAV is the calculated market price of the fund’s portfolio. In the past, most mutual funds were actively managed; however, nowadays there are a significant number of passive index funds. Mutual funds are either open-ended, with limitless shares trading, or are closed-end, which means the fund issues a set number of shares and likely has exit fees when investors divest. Mutual funds typically come with a higher minimum than ETFs and generally (not always) have higher fees.
What is an ETF?
ETFs or Exchange-Traded Funds are a relatively new investment option and were mostly passively managed to track a market index or sector sub-group. However, the number of actively managed ETFs today is growing. Unlike mutual funds, ETFs trade just like stocks and can be bought and sold throughout the day at a mark-to-market price. ETFs generally cost less for an entry position than mutual funds. Passively managed ETFs generally realize fewer capital gains so can be more tax advantaged. There are three types of ETFs: 1) Open-end; 2) Exchange-Traded Unit Investment Trust (UIT); 3) Exchange-Traded Grantor Trust. The bulk of retail investors (the average Joe) will invest in open-end ETFs. Lastly, because an ETF trades intraday, there is the possibility for arbitrage.
ETF vs. Mutual Fund – Bottom Line
ETFs have lower investment minimums
ETFS offer more control over the trade price since they provide real-time pricing. They trade just like stocks with a bid/ask spread, which offers pricing arbitrage.
ETFs and mutual funds offer passive and active management of a pool of securities, usually tracking and index or a sub-sector industry
ETFs are generally tax advantaged. Mutual funds are obliged to distribute any capital gains taken, which means the end investor (you) has to pay tax on the gains. ETFs usually avoid this issue as they rarely sell an individual stock, but rather swap it for another security.
Most ETFs are passively managed, which usually means lower fees than mutual funds. However, there are obviously exceptions to every pattern and expensive ETFs and cheap mutual funds can be found.
The biggest takeaway is that investors should be choosy. I will note a BIG caveat is that retirement plans (your company’s 401K or teacher pension plan) typically offer mutual funds ONLY largely because they have been around for longer, and long-term investment holders (like your retirement plan) are indifferent to capital gains. As such, you are usually unable to select ETFs in your retirement plan. So be sure to pay attention to the fund fees and select mutual funds that offer low (or none) sales loads and no exit fees upon divestment. Maybe in the future, ETFs will be an option for more corporate retirement plans.
All in all, when given the option of either an ETF or a mutual fund, the tax efficiency, liquidity, intraday pricing and generally lower fees make ETFs the winner in my book!
This is not an advertisement or solicitation for business, and my personal experience does not constitute universal application. Information is for informational and recreational purposes only. Each financial situation is unique, and you should do your own due diligence. Past performance does not guarantee future results. Some content may contain affiliate or referral links.
Jordan is the creator of Lifetime Tidbits and has spent more than 10 years working in finance, primarily as a securities trader. She holds her CFA charter and has been Series 7 & 63 licensed.