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Updated on Monday, April 20, 2020
Mutual funds and exchange-traded funds (ETF) are investment vehicles that make it easy to put your money into a mix of assets, providing investors with varying degrees of diversification. However, there are key differences between ETFs and mutual funds when it comes to how they are managed and how much they cost to invest in.
To determine which is better for your portfolio, here’s what you need to know about mutual funds versus ETFs.
- What is a mutual fund?
- What is an exchange-traded fund (ETF)?
- ETFs vs mutual funds: Differences and similarities
- Should you invest in ETFs or mutual funds?
What is a mutual fund?
A mutual fund is an investing vehicle that buys a highly diversified portfolio of assets — stocks, bonds and other securities — and sells shares in the fund to outside investors. Typically, financial professionals actively manage the mutual fund’s portfolio, watching the ebbs and flows of markets and undertaking in-depth research in a concerted effort to beat the market.
According to the most recent statistics from the Investment Company Institute, 92% of those who invest in mutual funds are doing so to save for retirement. Most of them invest in mutual funds via an employer-sponsored retirement plan. Beyond retirement, people also use mutual funds to save for emergencies and/or educational costs.
You may buy shares in a mutual fund directly from the firm that manages the fund or from a broker. Mutual fund shares can be bought and sold daily, though you can only do so once a day based on the net asset value (NAV), which is determined only once a day at the market’s close and is calculated by the fund’s value per share minus its liabilities.
Because they’re actively managed, mutual funds typically charge customers a variety of fees, which may include an expense ratio, distribution fees, fees for purchasing and selling and other fees. Most mutual funds also require a minimum investment, which is typically $500-$1,000 or more.
Passively managed mutual funds
While mutual funds are typically actively managed, there is a subset of mutual funds called index funds that are passively managed. Index funds buy a portfolio of assets in an attempt to mimic the performance of various indices, such as the Dow Jones Industrial Average or the S&P 500.
Because their makeup is largely predetermined and they’re made to “set and forget” rather than to be traded frequently, they are considered a passive investment. That means they typically don’t come with nearly as many fees as most mutual funds.
What is an exchange-traded fund (ETF)?
Like mutual funds, ETFs pool funds from outside investors and buy a portfolio of assets. Unlike mutual funds, however, ETF shares can be purchased and sold throughout the day, just like individual stocks, with the prices fluctuating along with the market.
Most ETFs are passively managed, meaning there’s no financial professional picking which assets to invest in and when to trade them. Instead, most ETFs mimic financial indices. ETFs typically come with fewer fees than mutual funds because they don’t require as much work on behalf of a professional manager.
Anyone can buy ETF shares, and you can buy as little as one share at a time. ETFs are only sold as full shares, however, so if you automatically invest a set amount of money on a regular basis, there may be funds leftover that sit uninvested until you have enough for another full share.
ETFs vs mutual funds: Similarities and differences
While there are various types of mutual funds and ETFs, in general, both investment vehicles provide a way to diversify a portfolio. These investment vehicles usually differ in how they are purchased, the minimum investment, and their overall cost.
ETFs are sold by the share and can be purchased throughout the entire trading day, with fluctuating prices just like stocks. Mutual funds, on the other hand, must be purchased directly from the fund and typically require a minimum investment. While you can place an order to buy or sell mutual funds any time during the day, transactions are only made once a day at the close of the market, and the price is calculated based on the NAV.
The minimum required investment varies, but most mutual funds allow investors to purchase partial shares, which is beneficial if you automatically invest a set amount of money, such a through a 401(k) plan. In contrast, ETFs can only be purchased by the share. That means if you automatically invest $50 each month, but the ETF shares are $40, then $10 would go uninvested until your next transaction when you can fund the full price of a share.
Both ETFs and mutual funds pool investors’ money to buy an array of stocks, bonds or other assets. They provide diversification, which minimizes risk if individual companies should tank. Neither mutual funds nor ETFs offer any guarantees, however, and they’re not insured by the government, so there’s always potential risk that you could lose money.
Most mutual funds are actively managed, with the exception of index funds. ETFs are usually passively managed, and buying and selling are often managed via a computer algorithm.
In general, mutual funds charge investors more fees because they require more work from an account manager or team of managers. ETFs are passively managed and require less work, so they tend to be less expensive, though there may still be fees associated with them. With both mutual funds and ETFs, the fees you must pay take away from the total amount you’re able to invest.
ETFs also typically come out ahead when it comes to taxes. When mutual fund shares are sold throughout the year at profit, shareholders are granted those gains, which means they’re then subjected to capital gains taxes. ETF transactions, on the other hand, are typically classified as exchanges and generally avoid capital gains taxes.
Note that if either your mutual fund or your ETF is within a retirement plan like a 401(k), you don’t have to worry about the taxes until you withdraw funds from the account.
Should you invest in ETFs or mutual funds?
ETFs may be a better choice for investors who prefer more flexibility and lower fees, while mutual funds may be a better choice for those who want more choices, are looking to try to beat the market and want a fund manager to actively make decisions about their investments.
While both offer benefits in terms of ease of use and diversification, they also come with fees, expenses and taxes that can reduce the amount you’re able to invest and potentially grow with compound interest. Also note that individual mutual funds and ETFs often vary greatly in terms of fees, risk and other details, so it’s important that investors carefully compare all funds they’re considering before making any investments. Thorough comparison shopping is the best way to ensure you know exactly how your money is being invested and to garner the best returns.