Mutual Funds are actively managed funds which consist of a portfolio made up of bonds, stocks, and various securities. An ETF on the other hand refers to a basket of securities that are tradable like stocks on exchanges.
There are quite a lot of things common between Mutual Funds and exchange-traded funds. Both of these types of funds are a representation of a common way for investors to diversify. Additionally, both of them consist of a mix of several asset classes.
If we have to look at the similarities for both ETFs and mutual funds, we have to take a look at some features given below.
Professionally Managed Basket: Both ETFs and mutual funds represent professionally managed collections known as baskets filled with bonds or individual stocks.
Professional Portfolio Managers: Professionals manage both ETFs and mutual funds. These professionals are experts in their respective fields, monitoring, and then choosing stocks or bonds for the funds to invest in. This saves a lot of time and effort for the investor.
Variety of Investment Options: Investors get access to a wide variety of International and U.S based stocks and bonds through mutual funds and ETFs. Investors can invest in a total market fund, or a high dividend stock fund, which depends on how narrowly and broadly they want to invest.
Less Risky than individual investments: The risk associated with buying and holding individual stocks or bonds of companies, is comparatively more than that of ETFs and mutual funds. This is because both these options come with diversification. For instance, if one stock underperforms and incurs losses, there is a possibility that other stocks have succeeded in turning in profits, which would balance out the overall loss.
What’s the difference?
Investors often go for either exchange-traded funds or mutual funds when they are looking to achieve any financial goal or save for their retirement. In spite of all the above similarities, we have seen, ETFs and mutual funds differ in several fundamental ways. This includes accessibility, fees, and expenses involved, tax efficiency, and even trading costs.
The current investor market is more attracted to ETFs despite the fact that they offer almost the same diversification benefits. However, the investor’s choice still depends on his/her overall goal and investing approach. Thus investors need to be aware of the key differences between the two, so that they can make a better informed choice.
Management: ETF’s are “passively managed”. This means that the funds automatically track a pre-determined index such as the NASDAQ 100 or S&P 500. Additionally, there are actively managed ETF’s in existence as well. They function in a similar fashion to mutual funds with comparatively higher fees. On the other hand, Professional managers usually run mutual funds. Using their investing expertise and experience, they attempt to beat the market by buying and selling stock on behalf of the holder. This type of management is active management. It involves higher expenses for investors. In the long-term, ETFs have a much higher return compared to mutual funds. This is because actively managed funds cannot beat the market on every try. Higher expense ratios are another factor. In the short-term, however, actively managed funds fair better in comparison with ETFs.
Expenses: An expense ratio is an indication of how much an investor pays on a yearly basis, for ownership of a fund. It is based on a percentage of the original amount invested. Mutual fund expenses are high when compared with passively managed ETFs. This is because ETFs are relatively a lot less expensive. The expense ratios for some ETFs are very low at 0.03%. This requires investors to pay a mere $0.30 on a yearly basis for every $1000 worth of investment. Statistics in 2018 indicate that the average expense ratio of ETFs is much lower at 0.15% than the 0.67% average expense ratio of mutual funds.
Trading process: In spite of being an index, ETFs trade throughout the day in a similar fashion to stocks. The forces of supply and demand usually determine their prices. Traders can use limit orders to control or execute trades. Put and call options trades are also possible with ETFs. This is not so in the case of mutual funds. The Net Asset Value changes after the trading session close of each day. Limit orders are not available with Mutual funds. Traders have to pay a commission when they buy or sell ETFs due to their stock-like structure. Currently, however, there are a lot of major brokerages who do not charge traders a commission when trading ETFs, options or stock. While this can be good news for those who are buying ETFs, most brokers still require traders to hold an ETF for a predetermined time period to avoid a fee. In short, ETF’s don’t perform well in day trading.
Assets and Cash Level: The costs of entry for mutual funds are pretty high when compared with ETFs. Even those mutual funds targeted towards beginner investors start from $1000 or above. It is less expensive to purchase ETFs by the share, which lowers the expenditure to add to a position or establish one. Professionals actively manage mutual funds. They select the assets in such a way as to beat the index it follows, achieving good performances. On the other hand, ETFs are tracking indices. This means they try to match the returns and price movements as a particular index indicates. They do this by building a portfolio, similar to constituents of the particular index. Fund management expenses are high for mutual funds as professionals manage the assets on behalf of the mutual fund holder. Thus it can eat away into profits. However, in the case of ETFs, fees and other expenses are low.
Taxation: Because of the nature of management, ETFs excel more when it comes to tax-efficiency than mutual funds. This is especially noteworthy for ETFs not in a retirement account (e.g. 401(k) or IRA) but in a taxable account. Buying an ETF essentially means that the investor purchases it from another investor. This means that the buyer pays taxes on capital gains from that single sale. This is vastly different in the case of mutual funds. They are structured in such a way that it incurs higher taxes on capital gains. Additionally, since mutual fund assets are more frequently bought or sold than ETFs, the taxes on capital gains are passed on to every shareholder of the fund. This means that an individual may have to pay capital gain taxes even if they haven’t sold their shares.
The Bottom Line
Mutual funds and ETFs both track indexes. However, while professionals actively manage mutual funds, an ETF tries matching the price movements and returns from the index it tracks.
Both ETFs and mutual funds provide a great way to achieve portfolio diversification. The ultimate decisions rest on factors such as the investor’s risk appetite and investment horizon, his/her tax-saving strategy, liquidity of the investment, and the investor’s financial goals.
ETFs have higher returns in the short- term and offer more flexibility than Mutual funds. Mutual funds on the other hand are more long-term in nature and require investors to stay invested for a considerably long period of time. So it ultimately depends on the financial goals and preferences of the individual. If an individual wants to actively take part in the management of his/her portfolio, then an ETF would be more suited for him/her. Alternatively, if an individual wants professionals to fully manage his/her investment, they should choose a mutual fund. Almost all ETFs and mutual funds involve expenses that may eat into returns. So investors should do their research, compare fees, and short-list options before making a final decision.