Anyone investing today will likely be exposed to one or both of mutual funds and exchange-traded funds (ETFs). As two popular and relatively similar investment vehicles, it’s important that investors know the difference between them and which one is more appropriate for their specific goals and financial situation.
In this piece, we will run down the basic tenets of both mutual funds and ETFs and highlight the key differences between the two assets.
A mutual fund is an investment in which cash is pooled by a number of individuals and then invested into stocks, bonds or other securities. There are different mutual funds for different specific goals, objectives, and areas of expertise. For example, some mutual funds invest only in the banking sector, while others invest only in pharmaceutical company stocks.
Due to the risks and barriers to entry involved with investing in stocks, many investors prefer to invest in mutual funds. Before choosing to invest their money, it’s important for investors to identify the mutual funds that match their objectives, have good past performance, and have an experienced management team at the helm. Another critical factor to consider while selecting mutual funds is the expense ratio that is calculated by dividing the total value of the fund by the total fund fees, including management fees and operating expenses.
Mutual funds can invest in equity, debt, or both. Equity funds allow investors to participate in the stock market and follow more of a high-risk-high-return profile. In contrast, debt funds invest the pooled money in fixed income securities and generally see lower returns, with lower risk. Some balanced mutual funds divide their investments between equity and debt.
Additionally, mutual funds can either be open or closed-ended. Open-ended mutual funds do not have a fixed maturity period and allow investors to enter and exit at any point in time. On the contrary, closed-ended mutual funds have a fixed maturity period.
Exchange-traded funds (ETFs) are a modified form of mutual funds. They are also funds that invest in different types of stocks, but they are tradable over a specific host exchange. Such trades and transactions carry a transaction cost as the brokers’ fee. ETFs are less diversified than mutual funds because they mostly concentrate on a specific asset class, sector or index. For example, some ETFs mirror the stock distribution of S&P 500 and use its performance to invest accordingly.
There is a wide variety of ETFs based on the securities they invest in. Thus, they can be equity, bond, currency, commodity, or real estate ETFs. Moreover, some ETFs are sector-specific, while many follow a specific index. ETFs are beneficial as they provide high leverage; when a sector grows by 1%, the linked ETF can grow by 2-3%. However, leverage also increases the chances of losses, so it has to be handled carefully.
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What do ETFs and mutual funds have in common?
ETFs and mutual funds have a lot in common. They are, in essence, variations of the same concept of pooling resources and investing that pooled money in a professionally-managed basket of financial instruments. Investors hold a small portion of the entire collection as their assets and earn or lose on their share.
Both ETFs and mutual funds are great for diversification and are seen as less risky than investing in individual stocks or bonds. Even if one of the stocks in the collection performs poorly, the others may do well and balance out the losses. Additionally, investors also get access to a wide variety of markets, sectors, and financial instruments based on their personal investment goals and styles.
Differences between ETFs and mutual funds
Beyond the basic similarities of diversification and pooled resources, the paths of ETFs and mutual funds diverge. They vary in many aspects that make them suitable for particular individual needs. Mutual funds and ETFs operate differently, and investors invest differently in them. The primary differences between mutual funds and ETFs include:
Tradability: The most predominant difference lies in the name itself. ETFs are traded on an exchange and can be bought and sold anytime in a trading session. ETFs do not have a minimum holding period, while mutual funds have a minimum lock-in period and charge a penalty for selling earlier. Mutual funds are not traded on an exchange and need to be bought and sold through the mutual fund managers. Moreover, mutual funds are priced once a day while the prices of ETFs fluctuate throughout the day.
Management: Most mutual funds are actively managed. Seasoned professionals buy and sell financial instruments held by mutual funds based on what they think will outperform the market. On the contrary, ETFs are usually passively managed. They attempt to track popular indices, sectors, or markets, and try to match their returns and performance.
Expense ratio: Since mutual funds are typically actively managed, they generally come with charge management and transaction fees. Therefore, the expense ratio for mutual funds is typically higher than passively managed ETFs. Also, the buyers and sellers of ETFs tend to interact with one another, while mutual fund transactions are performed by fund managers – again, this often makes them more expensive than most ETFs.
Size of funds: The size of mutual funds is usually unlimited. The number of financial instruments held by mutual funds does not remain fixed and keeps changing as and when investors buy or sell their holdings in the fund. On the other hand, ETFs are not open-ended. They have a fixed number of existing stocks that are traded in the market.
Taxation: Investments in both ETFs and mutual funds are taxed according to the profits and losses incurred. Investors pay taxes when they make short-term or long-term capital gains by selling their shares for a profit. However, ETFs are more tax-efficient due to less internal trading and their creation and redemption mechanism. Furthermore, mutual funds pay capital gains distributions to investors while ETFs do not, making the latter slightly more tax advantageous.
Are ETFs better than mutual funds?
Both ETFs and mutual funds are excellent avenues for diversified investment. They are managed, traded, and taxed differently; hence they have their own strengths and drawbacks. For investors who would prefer minimum initial investments without long lock-in periods, ETFs could be more suitable, while for those looking at lower expense ratios and more active management of their investments, mutual funds may work better.
However, for investors seeking lower fees, ease of access, and less day-to-day involvement with the performance tracking of their portfolio, ETFs are generally more suitable. They offer flexibility, liquidity, portfolio diversification, risk management, and tax benefits at a lower cost than traditional mutual funds and also offer access to a variety of market segments and sectors.