One of the most commonly touted “rules” of investing is to diversify your assets. That means buying different kinds of assets so you aren’t investing too heavily in one company or in one industry.
Rather than diversifying by manually buying stock shares in many different companies — each of which grants you an ownership interest in the company whose stock you buy — many people prefer to invest in either exchange-traded funds (ETFs) or mutual funds.
Both ETFs and mutual funds involve pooling your cash with the money of lots of other people. That pot of money is then used to buy a mix of different assets in order to minimize risk.
While there are similarities between ETFs and mutual funds, there are big differences in how these two kinds of investment products work. Learn more about investing in ETFs versus mutual funds below so you can make the most informed choice about which type of investment is best for your situation.
ETFs vs. mutual funds: the basics
Both ETFs and mutual funds give you exposure to multiple individual securities. But ETFs and mutual funds differ in how they’re sold, their typical fees and costs, their initial starting investment requirements, and often the way they’re managed.
ETFs are traded like stocks, and you can buy as little as one share of an exchange-traded fund. The price fluctuates throughout the day and is determined by what investors bid and what sellers are willing to sell for. There are many ETFs you could buy a share of for under $25.
Mutual funds, on the other hand, require investors to buy into the fund directly, which can happen only once per day, after the market closes. The minimum investment in a mutual fund is often much higher than the minimum investment for an ETF, and the price is determined by the net asset value (NAV), or how much assets in the mutual fund are worth minus liabilities.
While ETFs often cost less than mutual funds and can be easier to buy and sell, this isn’t the case for every ETF and every mutual fund, so it’s important to comparison shop carefully if you’re considering investing in either of these two types of financial products.
How it’s traded
What is an ETF?
An ETF, or exchange-traded fund, gets its name because it is traded on a stock exchange, such as the Nasdaq or the New York Stock Exchange. Anyone can buy an ETF, and you can buy as little as one share. You’ll need to have some money in a brokerage account to buy an ETF, but it’s easy to open an account with an affordable online broker.
You usually have to pay a commission to buy an ETF, just like you pay a commision to buy stock shares in a company, but some ETFs are commission-free. The commission you pay is a flat fee when you buy and sell, and it’s paid to your broker. For example, if you invest with Ally Invest, you pay a $4.95 commission to Ally when you buy shares of an ETF and pay the same $4.95 when you sell your shares.
If you have to pay a commission, you may want to wait until you’ve saved up a little bit of money to buy multiple shares. Buying just one share is possible, but you’d need to make a bigger profit to make up for the fee.
Many ETFs are passively managed, which means there’s no financial professional picking which assets the fund will invest in. Instead, ETFs usually track financial indexes, such as the S&P 500 or the Dow Jones Industrial Average.
You can buy ETFs to gain exposure to many different kinds of assets. ETFs could give you exposure to U.S. or foreign stocks as well as bonds, real estate and more. You could buy a few different ETFs to get a fully diversified portfolio, or you could use a robo-advisor to help you invest in an appropriate mix of ETFs.
When you buy even a single share of an ETF, you gain exposure to everything the ETF is invested in. If you buy an ETF that tracks the performance of the Dow Jones Industrial Average, for instance, you have a small interest in the 30 large publicly owned companies in the U.S. that create this average. If these companies perform well, your ETF should increase in value.
What is a mutual fund?
A mutual fund is a pool of money that is invested in a mix of different assets, just like an ETF. But unlike an ETF, you don’t buy shares of a mutual fund on a stock exchange. Instead, you have to buy shares directly from the fund or directly from a broker for the mutual fund.
You also can’t buy or sell shares of a mutual fund whenever you want; you can buy shares only at the end of each day. And unlike an ETF, the price isn’t determined by what investors will pay for it on the market. Instead, each day, the net asset value of the fund is determined by adding up the fund assets, subtracting liabilities and dividing this amount by the number of outstanding shares. When you purchase shares of the fund, the NAV is the price you pay.
In most cases, you’re required to invest a certain minimum amount to be able to buy into a mutual fund. Often, the minimum is at least $1,000. With some mutual funds, it is much higher. Selling your fund can take more time too. While “redeemable” mutual fund shares can be sold back to the fund at any time, funds usually have around seven days to send you back your money once you redeem your shares.
Mutual funds may charge a number of fees, which are often higher than the costs of ETFs. These fees can include management fees, which can sometimes become quite costly. The reason for these added costs is that most mutual funds are actively managed, which means someone selects investments that are made with the pooled money in the fund. The money isn’t just invested to mimic a financial index or by some other automated process.
ETF vs. mutual funds: who should invest in which?
If you’d prefer more flexibility and potentially lower fees, an ETF may be a better choice for you. But if you want a fund manager to make decisions about where your pooled money will go, you’ll have many more choices with mutual funds.
With either type of investment, it’s important that you research the performance of the fund carefully. You’ll want to know what it costs to buy and sell, the management fees you’ll pay, and how the investment has performed over time.
You may decide to invest in a mix of mutual funds and ETFs, or you may choose one over the other — just make sure you understand fully what you’re getting into and how your money will hopefully grow.
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