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ETF vs mutual fund: How is an ETF different from a mutual fund?

When considering the difference between ETF and mutual fund options, it’s easy to get confused. They have many similarities. They both work with a mixture of various kinds of assets, and they both give investors a chance to diversify their choices of assets, thus lowering the element of risk.

What is an ETF vs mutual fund?

An ETF is a kind of investment that is based on stocks being traded via an exchange market. It can hold a variety of assets, including stocks and bonds, commodities, and also currencies. An ETF allows trading to take place throughout the day. Many ETFs now work through Robo advisers.

A mutual fund consists of a number or pool of investments or money that is collected from numerous investors. The money is then used for lump investments in stocks and bonds, and other assets that have the potential for high returns. They are usually managed in an active way by professional fund managers.

What is ETF vs mutual fund investing?

When comparing ETF vs mutual fund vehicles, there are some important differences. They include the way the funds can be traded and the way they are managed. 

But the fact of the matter is that of the two, ETFs are very much in the ascendancy right now. In this article, we are going to look at not only how is an ETF different from a mutual fund but what that means to you, the individual investor. We will begin with how the two are managed.

The management difference between ETF and mutual fund and index fund

Mutual Funds typically get managed by a professional manager. They use their knowledge and expertise to beat the market by trading (buying and selling) stocks. This type of management is described as “active management,” and it usually means higher costs as far the investor is concerned. 

One of the big advantages of ETFs over mutual funds (and this goes for index funds too) is that they are passively managed. They track indices like the FTSE 100, the Nasdaq, or the S&P 500, automatically. This is the case with the majority of ETFs, but you can get a few that work more similarly to the way mutuals work, and accordingly, higher fees are incurred.

The difference in terms of expense ratios

The term “expense ratio” refers to how much an investor will pay per annum, expressed as a percentage of the value of the fund. Generally speaking, ETFs, being passively managed, are relatively cheap. That being said, this is not always the case. It’s always worth checking it out before you commit yourself. 

In the short-term, actively managed mutual funds can perform better than ETFs, but that is not often the case in the long term. Given the higher expense ratio and the improbability of continually beating the market, actively managed mutuals often produce lower returns than ETFs over time.

The difference in terms of trading

In the majority of instances, an ETF tracks an index. Okay, I hear you say, so do mutual funds. Indeed they do, but the ETF mutual fund difference is that while mutual funds are bought and sold at the end of each trading day, the assets in ETFs can be traded throughout the working day, just like stocks. 

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The stock-like trading attribute of ETFs does open them up to incurring commissions. But with the ever-increasing competition between traders and brokerages, this is becoming less common. The only thing to bear in mind is that the majority of brokers often require you to keep hold of an ETF for a minimum number of days. If you don’t, they will levy a fee, so that is something you should be aware of.

Minimum Investment Requirements

Another difference between ETF and mutual fund vehicles is that mutuals often have high entry costs. This can also apply to target-dated mutuals. These are funds that are designed to help novices save towards specific ends, but they often involve minimum investment sums of £1,000 or more. 

ETFs on the other hand, can be purchased by the individual share (and even fractions of shares), thereby reducing the cost of either establishing a position or maximising an already existing one.

The tax advantages of ETFs over mutual funds

When it comes to taxation, ETF vs mutual fund vehicles are basically taxed in the same way as other investments. In other words, you have to pay tax if you are selling shares at a profit. This is, of course, capital gains tax. 

In any one tax year, any profit up to a threshold of £12,000 is free from capital gains, but above that figure, it becomes liable.

You have the option of paying either short-term capital gains or long-term. Short-term relates to shares that have been held for less than 12 months before they’re sold. Long-term refers to profits from shares that have been sold after you’ve had them for over 12 months. If you do fall under the capital gains tax axe, the income tax bracket you fall into will be relevant.

When comparing the ETF vs mutual fund options, you need to bear in mind that mutuals’ active management often means that stocks are bought and sold more frequently. Where this results in a profit, it incurs capital gains tax, and this is passed on to each investor with shares in that fund even though you might not have sold your shares.

ETFs vs mutual funds long-term implications

Whether you are considering ETFs or mutual funds, both can be good vehicles for investors. If your main priorities include lower expense ratios and greater flexibility in trading, then an ETF could be the right choice for you. 

However, if you are more concerned about paying commissions, premiums, or any other factors that might impact on the value of your shares, and you think you would benefit from help with managing them, then a mutual fund might be the better choice.

Before arriving at a final decision, the most important thing you have to consider is the level of risk that you are willing to take. Depending on your knowledge of such matters, we would usually recommend talking to professional financial advisers before committing yourself to any specific financial product.

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