When deciding how to invest your money, you’ll likely run into two types of funds: exchange-traded funds (EFTs) and mutual funds. But you may be wondering, ETF vs. mutual fund? What’s the difference? The two funds have a lot in common, but they are different in key ways. If you don’t have a financial advisor guiding you through the process, here’s what you need to know to figure out which fund is right for you.
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ETF vs. Mutual Fund: The Similarities
At their cores, ETFs and mutual funds are quite similar. Both types of funds are collections of shares of many different stocks or bonds, grouped together and traded as one unit. Experts manage the funds, keeping track of each security within the fund. The fund’s performance is based on the performance of the individual stocks within the fund and the total number of shares.
Since both funds are a collection of securities, they are great ways to add diversification to your portfolio in one fell swoop. Both types of funds offer options that mirror major indexes, like the S&P 500, thus providing you with a diverse fund reflecting the market as a whole.
You can choose from a variety of ETFs and mutual funds, depending on your investment goals and interests. Both ETFs and mutual funds offer bond funds, stock funds and sector funds, each of which has its own pros and cons. Whether you want to increase your investment income or mitigate your risk, there is a fund appropriate for you.
ETF vs. Mutual Fund: The Differences
Core similarities aside, ETFs and mutual funds have some major differences when it comes to pricing and purchasing, management and fees and taxes.
Pricing and Purchasing
ETFs trade like stocks. You can buy and sell shares throughout the day, and the price fluctuates with the market and with supply and demand of that particular ETF. Trades can be made through your broker or brokerage account. You have the option of purchasing as little as one share in an ETF.
You buy mutual funds through a fund company, such as Vanguard or Fidelity. A mutual fund’s value is a net asset value, computed once per day based on the closing market prices of its securities. You purchase mutual funds based on value, not on number of shares. Mutual funds require a large initial investment, with minimums over $3,000. Minimums can run as high as $50,000.
Management and Fees
Since ETFs trade like stocks, you’ll be paying trade commissions to your broker every time you buy or sell. The funds themselves are set up as indexes, either mirroring a major index or focusing on a certain industry. Like stock shares, the shares of an ETF are held by a management company. The shares of an ETF are bought and sold directly. Annual fees for ETFs are typically low – below 1%.
Mutual funds are created by pooling money from all investors to buy shares of securities with the pooled money. Typically, a fund management team actively manages mutual funds. These analysts chart the activities of the securities in the fund. They also research new companies, and buy or sell as appropriate to grow the fund. However, there is a type of mutual fund that doesn’t require management: index funds. These contain securities that replicate the activity of the market as a whole and thus don’t require day-to-day management.
Mutual funds make money through fees. Some mutual funds charge a load fee of 3% – 6%, which you must pay either when you make your investment (front-end load fee), or when you sell your investment (back-end load fee). No-load mutual funds are also available, but these will charge other fees, such as annual expense ratios.
The biggest difference between mutual funds and ETFs when it comes to taxes is that mutual funds tend to create a lot of capital gains for clients, while ETFs don’t. Depending on the state you live in, capital gains could be taxed at a fairly high rate, meaning that mutual funds may be creating a tax burden that ETFs won’t.
Mutual fund investors also typically pay taxes for the turnover within the fund, since other parties buying or selling shares directly affect the size of the fund.
ETF vs. Mutual Fund: Pros and Cons
Choosing whether to invest in an ETF or a mutual fund is an important choice. There are advantages to each of the choices, so you’ll need to think carefully about what each of them bring to the table before directing your money toward any investment project.
- More flexibility: ETFs are bought and sold on the market like stocks, so you can sell your shares whenever you want
- Tax efficiency: ETFs generally don’t create capital gains, meaning your tax burden may be less than with a mutual fund.
- Lower fees: ETFs often have lower fees than mutual funds.
- Lowe minimum investments: With mutual funds, the minimum investment is set by the fund management and could keep some people from investing. With ETFs, you can buy as few as one share of the fund.
Mutual Fund Pros
- More likely to be actively managed: If you are interested in active management, where a fund manager is trying to maximize your return rather than just tracking the market, a mutual fund is more likely to offer this.
- No commissions: ETF trades come with commissions, while mutual funds generally do not.
The Bottom Line
ETFs and mutual funds are both great options for diversifying your portfolio. They spread your investment across an index of securities for the cost of just a few shares. Deciding between an ETF and mutual fund depends on how much you have to invest, your desired level of management and your short-term and long-term investment goals.
Tips for Choosing Investments
- Consider how soon you want your money back. If you’re saving for the short-term, like for a down payment for a new house, an investment like a mutual fund won’t be right for you.
- Decide how hands-on you want to be. Figure out ahead of time if you want an expert calling the shots, or if you have the time and interest to do it yourself. A financial advisor can help with identifying and reaching goals, as well as taking on much of the work. A matching tool like SmartAsset’s SmartAdvisor can help you find a person to work with to meet your needs. First you answer a series of questions about your situation and your goals. Then the program narrows down thousands of advisors to three fiduciaries who meet your needs. You can then read their profiles to learn more about them, interview them on the phone or in person and choose who to work with in the future. This allows you to find a good fit while doing much of the hard work for you.
- Be aware of the fees and charges involved. As is the case with an ETF vs. mutual fund, trading and management fees vary, as does tax efficiency.
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