One of the most popular ways to invest is to make use of funds. Funds offer investors the ability to diversify quickly and easily. They can be low-cost when held over a longer period of time. Investors have the option to choose between two different types of funds: mutual funds (including index funds) and exchange-traded funds (ETFs). Let's dive into this ETF vs Mutual Funds comparison.
In this Comparison:
What Is an ETF?
Exchange-traded funds (ETFs) are a little different. ETFs are composed of units of underlying investments. They are created and redeemed in large lots. They trade like stocks on the market.
This means the price changes regularly throughout the day, and they are more flexible than mutual funds. Dedicated apps like Public make it easy to buy and sell ETFs.
Like mutual funds, you may have to pay a yearly fee — called an “expense ratio” — but the fee is often quite small with an ETF. Plus, there is no need to sell investments held in an ETF when an investor wants out. This means that you are unlikely to be surprised by a capital gains tax due to fund turnover.
Read our complete ETF 101 guide to find out more.
Who Should Invest in ETFs?
Invest in ETFs if you are more interested in asset allocation and less interested in picking individual stocks. ETFs offer a little more flexibility than mutual funds, in that they can be traded like stocks on the exchange. You usually don't have to worry about load fees, and you can trade throughout the day. However, these investments work best for those who plan to use them for long-term investing.
Where to Invest in ETFs
You can invest in ETFs just about anywhere that offers stock trading. Most traditional and online brokers offer ETFs. In most cases, their transaction fees are the same as for stocks.
Additionally, many robo advisors use ETFs in their portfolios. If you're using a robo advisor like Betterment or Acorns, your portfolio will be made up of ETFs. You can find out our top recommended commission-free brokers for ETFs here.
What are Mutual Funds and Index Funds?
Mutual funds are collections of investments. With actively managed funds, fund managers change the composition of the fund to meet certain goals. But index funds follow the investments on a specific index and don't need to be constantly updated by a manager.
- Index funds have relatively low fees, while other types of mutual funds often have fairly high fees. Many mutual funds come with sales loads. (A “load” is a percentage paid to the broker when you buy or sell a mutual fund.) And actively managed funds also have rather high administrative fees.
- When an investor wants to sell their shares in a mutual fund, the fund company redeems them. This usually creates either a capital gain or loss, depending on the price when the shares are sold. This means you could end up paying a capital gains tax because of mutual fund turnover, even though you didn't sell your shares.
Who Should Invest in Mutual Funds?
Mutual funds are ideal for investors who want access to instant diversity in their portfolio without picking individual stocks. With a mutual fund, you can set up an asset allocation based on your risk profile. In general, mutual funds work well for long-term, passive investing, where the investor doesn't expect to do a lot of trading.
Where to Invest in Mutual Funds?
You can find mutual funds with many online brokers, including Ally Invest, E*TRADE, Fidelity and Vanguard. However, you may need to have a minimum amount of money to invest in mutual funds. Also, pay close attention to the fees associated with mutual funds since some of them carry different fees that can impact your overall returns.
Check out our guide to the best brokers for mutual funds here.
What's the Difference Between an ETF and Index Fund?
An index fund is a type of mutual fund that tracks an index, such as the S&P 500 or the Nasdaq. If you invest in an index fund, your portfolio will follow the movements of the index. So when the stock market is up, your investments will increase, while the opposite will happen when the market ends the day in the red. This is because index funds, just like mutual funds, only trade once the market closes.
With an ETF, you invest in a basket of assets that trade like securities. They trade like stocks throughout the day and can be composed of various types of underlining stocks. For example, you can have an ETF that follows an index, a specific sector like technology, or even a commodity like oil.
Comparison Between ETF vs Mutual Fund
Both of these types of funds share some characteristics:
- Mutual funds and ETFs are both linked to the investments held in the funds.
- And they provide the opportunity to buy several investments in one purchase.
While there are many things in common between ETF vs Mutual Fund, there are also some key differences. Here's what you need to know.
Similarities Between ETFs and Mutual Funds
Exposure to a Variety of Securities
The biggest similarity between mutual funds and ETFs is that these investments offer exposure to a variety of securities with one trade or one ownership share. If you invest in a bond mutual fund or a bond ETF, you gain exposure to dozens — or even hundreds — of bonds with one vehicle.
Both Charge Expense Ratios
Both ETFs and mutual funds charge expense ratios. You'll see the expense ratio expressed as an annual percentage.
Indexing is Available with Both Types of Investment
It's also possible to take advantage of indexing with both types of investments. There are index funds and index ETFs. This allows you to focus on a particular index as part of your investing strategy, whether you use mutual funds or ETFs.
Differences Between ETFs and Mutual Funds
Ownership of the Underlying Assets
One of the biggest differences when comparing ETFs vs. mutual funds is ownership of the underlying assets.
- When you purchase a share of a mutual fund, you own a sliver of each asset in the fund.
- But when you buy an ETF, that's not the case. ETFs are constructed of creation units, and that's what you're buying — not the underlying asset. However, by purchasing the ETF, you still get exposure to the performance of the underlying assets.
ETFs are Traded Like Stocks, Mutual Funds are Not
It's important to note that mutual funds aren't traded on the market like stocks. Settlement (determining price and how many shares you buy) takes place at the end of the day, based on various factors. But ETFs trade like stocks on public exchanges and can be traded throughout the day.
Because ETFs are traded like stocks, you can program specific transactions, including limit orders, stop-loss orders, and other types of trading orders. Plus, you can trade when you believe the price is in your favor. With mutual funds, you don't have that level of control over your trading.
Keep in mind that there may be extra fees associated with mutual funds. Double-check to see what kind of load fees come with a mutual fund. Generally, ETFs come with lower expense ratios than mutual funds and can cost much less. Many brokers offer fee-free ETFs where they don't even charge transaction fees when you trade.
Know the Difference Between ETF and Mutual Fund Before You Invest
Mutual funds and ETFs offer many of the same advantages. They provide a way for you to gain instant diversity in your portfolio by making a few investments without the need for individual stock picking. Both offer access to indexing strategies and can be used well with asset allocation strategies, especially in long-term investing.
However, there are some important differences, including ownership of the underlying assets and how ETF and Mutual Fund are traded. Pay attention to these differences when deciding what's likely to work best for you.
In the end, though, you can have a mix of mutual funds and ETFs to meet your investing and financial goals.