Both a mutual fund and exchange-traded funds (ETFs) are important parts of the modern investor’s portfolio. But what are the differences between these two investment vehicles? While ETFs are in some ways a special kind of mutual-type fund, there are a number of dissimilarities that can make a big difference in financial strategy. Here we’ll outline the basics of the two fund types. Also, we’ll help you decide which is the best for your investment success.
What Is a Mutual Fund?
A mutual fund is a kind of cooperative investment vehicle. For most investors, this means adding your funds into a pool. The fund’s managers invest it in a wide variety of securities and asset types. These managers develop, structure, and maintain the fund’s portfolio to meet its stated investment goals.
Such funds have a long history, first appearing in Europe among Dutch merchants in the 18th century. They reappeared in the 1890s in the United States. They gained popularity over the course of the last hundred years and especially since the 1970s. Today, these funds are a key element in the finances of millions of people, including 43 percent of all American families.
The basic purpose of a mutual fund is to give smaller, individual investors a chance to participate in a highly diversified and professionally maintained portfolio. The manager carefully selects a variety of different investments. He then buys, sells, balances, and strategizes for the fund, aiming to maximize returns and pursue the aims of the investors. These investors benefit from the fund proportionally, depending on how much they have invested in it.
What Is an Exchange-traded Fund (ETF)?
ETFs are also a pooling of capital by multiple investors. However, ETFs are themselves marketable and trade on the markets like a stock. Just like stocks, ETF prices change throughout the day with the patterns of buying and selling. An ETF offers both the diversification and asset-pooling qualities of other funds. Also, it offers the risks and benefits of actively traded securities.
ETFs first emerged around 1989 and became widely available in the United States in 1993. There has been some controversy regarding ETFs and their structure and regulation. However, today they are an established part of the world of finance.
Many kinds of ETFs are available. These are usually classified according to the type of underlying assets, such as stocks or other securities. Most ETFs have been index funds. This means that they passively track the market as a whole or some segment of it. However, some ETF fund managers today actively or intelligently calibrate the fund’s portfolios.
In general, ETFs offer low costs and higher tax efficiency in comparison to other types of funds.
What Is the Difference Between ETFs and Mutual Funds?
A mutual or other type of fund is a pool of investments in securities or other assets. However, an ETF is itself a security or asset traded on the market. Beyond this fundamental distinction, there are a number of important differences between the two investment types.
- Structural Differences
The basic structural distinction between ETFs and other funds has to do with the type of ownership of the underlying assets. With ETFs, investors own shares in the fund itself and only indirectly own the underlying assets. On the other hand, participants in a mutual-type fund actually own proportional shares in the companies or other assets held by the fund
Since most ETFs are passively managed, they tend to have lower associated costs than actively managed funds. This is typically expressed as a lower expense ratio. For the consumer, this means fewer fees and lower initial cost of investment. With traditional funds, investors pay extra for the fine-tuning and daily management of the fund by its expert managers. Nevertheless, relative costs of each type of fund can differ greatly based on the size of the investment.
- Trading Methods
Since the markets treat ETFs like stocks, they are bought and sold throughout the trading day whenever the market is open. Investors can use any of the trading strategies available for stocks with their ETF shares, and there is no minimum investment involved. Marketable ETFs have significantly more flexibility than other types of funds. This is beneficial to traders, but may be of less interest to long-term investors.Mutuals, on the other hand, only trade at the end of the day and do not permit the many stock-like trading methods allowed with ETFs. Since the aim of such funds is careful management and attention to the fund’s goals, they tend to be more stable.
Sales inside an actively managed mutual-type fund generate capital gains, which are passed on to the fund’s investors. The investors will then be liable for taxes on these gains. Passively managed ETFs, however, generate fewer capital gains because of less internal buying and selling. They also do not distribute the gains from these trades to the shareholders. Typically, this means a smaller tax burden for ETF investors.
Many ETFs are sold by start-ups and smaller providers. The viability of the funds depends on how well these companies survive in the market. For this reason, many people choose to invest only in ETFs offered by well-established companies. This is less of a concern with mutual-type funds.
So, Which One Is Best for You?
Investing in an ETF means gaining the large-scale diversification of an index fund. It also means having the ability to trade the investment like a stock. Expense ratios will usually be lower and the tax burden may be significantly lighter than with a similar investment in a mutual fund. Commissions on trades will be the same as for any other stock trade.
ETFs are especially good for those with smaller amounts to invest since the barriers to entry are lower. Beginning investors who can benefit from the flexibility of ETFs should also consider these kinds of funds.
Mutual-type funds feature more initial investment, higher fees, and potentially greater tax burdens. However, they provide significant stability benefits and can also offer diversity to your portfolio. While active management has its critics, there are funds that consistently outperform the market. Generally, established investors interested in target-date strategies should consider a mutual fund before ETFs.
Although ETFs have many attractive features, especially for smaller investors and beginners, they retain certain risks associated with their stock-like features. A mutual fund, while coming with higher costs, avoids some of the pitfalls of marketable securities. Investors must carefully consider the relative weight of these two types of investments in their portfolios. They also need to adjust the proportions according to their goals.
Despite their differences, both are still viable investments for every kind of investor. Whether ETFs or a mutual fund will best help you to meet your financial goals, a key aspect of investment is careful consideration of the details of each fund. No two funds are identical, so you should carefully scrutinize a fund’s holdings, management strategies, and past performance before investing.