With interest rates at rock bottom for the last five years, saving for retirement or making sound decisions with your money is no longer as simple as putting it in a traditional savings account. Rather, an important avenue for many everyday savers looking to enhance or diversify their finances is to invest in exchange-traded funds (ETFs) or mutual funds. But which is right for you?
Both mutual funds and ETFs hold portfolios of bonds, stocks, precious metals and/or commodities. And both are useful for providing diversified exposure to a particular asset class, region, or market niche without the need to choose between individual securities.
But there are also some key differences between ETFs and mutual funds in how they are managed, traded, and the costs associated with purchasing and holding them.
For example, ETFs can be traded like stocks and typically have lower expenses associated with them because they are passively managed, seeking simply to replicate the performance of a particular index such as the S&P 500.
On the other hand, mutual funds can only be purchased at the end of the day, typically from investment companies rather than from other investors on an exchange. They are also actively managed, meaning that a fund manager will decide where to allocate assets in the fund. This typically results in higher fees but can provide greater regulatory oversight and better performance.
Which you choose will depend on your investment goals and your level of comfort making decisions about your own portfolio. So, before you download one of the latest investment apps and get your money on the move, let’s take a look at ETFs vs mutual funds in detail.
What Is an ETF?
ETFs are mostly passively managed fund that seeks to replicate the performance of a particular index. That means that, rather than a fund manager making decisions about asset allocation, an ETF will simply attempt to match the returns and price movements of an index by creating a portfolio that matches its constituents.
Because they are passively managed ETFs typically incur lower charges. For example, it is common to find ETFs charging less than 0.1% in management fees, while some even charge nothing at all. The expense ratio for actively managed mutual funds is anywhere between 0.5% and 2.5%. That’s a considerable difference!
When you combine this with the fact that many brokerages now offer commission-free trading (where it has historically been the case that investing in ETFs incurred trading commissions), ETFs can represent a much cheaper option compared with mutual funds.
Just like individual stocks, ETFs are traded on exchanges with other investors, rather than purchased from investment companies. That means that you can buy and sell the ETF any time you like during a particular trading session, and the price you get will be whatever the current price is on the market. Importantly, there’s also no minimum holding period for ETFs, meaning you can buy and sell them as frequently as you please.
What Are Mutual Funds?
Like ETFs, mutual funds comprise a portfolio of stocks, bonds, and/or other assets. Rather than trading them with individual investors, you typically purchase a mutual fund from an investment company such as Fidelity, BlackRock, or Hargreaves Lansdown.
Rather than trading whenever you like on an exchange, mutual funds only allow transactions once in a day, and purchases are executed at the net asset value of the fund based on its price when the market closes. Importantly, mutual funds are meant to be held for longer periods of time, rather than actively traded. As such, some will penalise you for selling early – sometimes as much as 1% of the shares’ value.
Mutual funds, like most ETFs nowadays, have no trading commissions, but they do have an expense ratio and possibly other sales fees associated with them. Although there are some passively managed mutual funds that track an index, most mutual funds are actively managed. This means that the fund managers will try to beat the market by using particular investment strategies and buying and selling the portfolio’s securities in a way that doesn’t simply track an index.
This style of management is often more expensive because money must be spent on research and analysts. However, it offers the opportunity for greater returns on your investment so long as the fund manager performs well.
Importantly, just because a fund is actively managed doesn’t mean it will automatically perform better than an ETF, especially in a buoyant market. It does, however, typically mean that you will have greater protection in a volatile market because fund managers can shed risky assets in favour of more conservative investments and downside protection.
Some Key Differences Between ETFs and Mutual Funds
- Investment Amount. Compared with ETFs, mutual funds normally require a higher investment amount. That means that you have to invest a minimum sum, which can be several hundred or even thousands of dollars, in a single transaction. ETFs, however, cost far less for an entry position. It can be the cost of a single share, for example, plus any associated fees or commissions. Some brokerages are even facilitating fractional shares, meaning you could purchase parts of a single share.
- Costs and Ongoing Fees. As mentioned, ETFs typically incur lower fees than mutual funds due to the fact that they are passively, rather than actively, managed. It’s important to keep an eye on “fee creep”, however. Some ETFs will boast fee waivers that lower the expenses for investors, but over time these can be reinstated; ensure you check the ETF’s prospectus to find out the waiver’s expiration date.
- Trading. ETFs are traded on an exchange with other investors. This means that you can perform intraday trades, limit orders, stop orders, and short selling, and there are no minimum hold limits. This isn’t the case with mutual funds, which can only be purchased from investment companies are the end of the market session and can incur penalties for premature selling.
- Performance. With an ETF, you can still secure sizable returns on your investment, but you’ll never be able to outperform the market. Mutual funds, if they are managed well, offer the opportunity to outperform the market using a specific strategy (most aren’t able to do this consistently, though). They can also offer greater downside protection in a volatile market.
- Tax Efficiency. One final point of comparison between ETFs and mutual funds is tax efficiency. As a mutual fund manager invests and liquidates investments, they realize capital gains – and those are taxed. Because there is less activity on an ETF, it incurs less capital gains tax. You can find out more about the tax efficiency of ETFs vs mutual funds from Fidelity.
Which Is Right for Me?
There is no definitively correct answer. Both ETFs and mutual funds offer distinct advantages and disadvantages, and each can fill the particular needs of an individual investor.
As always, diversification is a wise strategy. Picking a combination of both mutual funds and ETFs can offer you exposure to the short-term performance benefits of an actively managed mutual fund while providing the more straightforward exposure to long-term gains that come with an ETF.
For investors who want simplified, low-cost, and easy-access investment vehicles, ETFs offer exposure to a wide variety of market segments. And they are great for building a broadly balanced portfolio with which you can accumulate wealth in the long term. They also shift the onus of investment decisions onto you, however, rather than capitalizing on the expertise of an experienced fund manager – so ensure that you are comfortable making those kinds of choices.