Exchange-traded funds (ETFs) and mutual funds are two great ways to dive into the world of investing. What are they? You can think of a mutual fund as a basket of stocks and bonds. Similarly, an ETF invests in a range of different securities but trades like a stock itself. So whether you want to invest in small, mid-size or large companies or in a particular sector, you’ll likely find a mutual fund or ETF that’s right for you. As you learn more about the nuances of ETFs and mutual funds, you should also seek the help of a financial advisor, who can help you guide you through the investment choices that will work best for your needs.
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Mutual Funds vs. ETFs: How Do the Costs Compare?
Looking at the expense ratio is the easiest way to gauge how costly an investment is. Expressed as a percentage, it refers to the amount of a fund’s assets that are used to cover administrative costs. The lower the expense ratio, the smaller the bite that’s taken out of your earnings.
In terms of the expense ratio, ETFs tend to have the edge because many of them track a market index and are passively managed. There are many index mutual funds, too. But many more are overseen by a fund manager.
Morningstar’s annual U.S. Fund Fee Study illustrates how wide the gap is between actively and passively managed funds. While the average asset-weighted expense ratio for active funds was 0.67% in 2018, the average ratio for passively managed funds was 0.15%.
Where Commissions Fit in
When you buy or sell shares of a mutual fund or ETF through a brokerage firm, you’ll typically pay a commission to your broker for each transaction. With a discount brokerage, the fee can be as low as $7 per trade. But a full-service broker typically charges a much higher premium.
When you’re choosing a mutual fund, you can get around the commission fee by buying directly from the mutual fund company. (Picking a no-load fund will also help you save.) With many ETFs, on the other hand, you don’t have that option. Since exchange-traded funds are traded like stocks, the fees can quickly add up if you’re executing multiple trades throughout the day.
Another advantage of ETFs is that they don’t have minimum starting balances. You can buy as little as one share, unlike many mutual funds. So if you don’t have a lot of money to play with, ETFs may be the way for you to go. Also, look for discount brokers with commission-free funds.
Tax Efficiency of ETFs vs. Mutual Funds
Aside from the upfront costs, investing in ETFs or mutual funds can have an impact on your bottom line at tax time. When the assets in a particular fund appreciate in value and those securities are sold, this results in a capital gain for the fund as a whole. Capital gains are then passed on to shareholders, typically in the form of a year-end distribution. Any gains you realize are subject to capital gains tax and depending on your income, you could end up owing more to Uncle Sam when you file your return.
Exchange-traded funds are usually considered to be more tax efficient because of how they’re structured. Passively traded ETFs typically have fewer capital gains distributions for individual investors compared to mutual funds.
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The Bottom Line
Between the two kinds of funds, exchange-traded funds are a more cost-effective choice when you consider the expense ratio and the tax implications. The fact that the initial investment can be lower only adds to their appeal. Just keep in mind that commission fees could cancel out your savings if you’re doing a lot of trading.
- Regardless of whether you decide to invest in mutual funds or ETFs, you should stick to options that adhere to your risk tolerance. The key is to diversify your investments based on risk tolerance. You can use our asset allocation calculator.
- If you’d like to work with a financial advisor, we can help you find one. Use our SmartAsset financial advisor matching tool. Simply answer a few questions about your goals and the tool will link you with up to three local advisors. You can compare their qualifications and set up interviews before you decide to work with one.
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