What’s the difference? Which is better?
When you begin looking to invest, odds are you’ll likely come to come to the crossroads of exchange-traded funds (ETF) and mutual funds. If you’re like most people, the next question you ask is what even are these, what’s the difference, and which is better?
While the answer to which is better can only be made by the investor since it depends on their investing objective the other questions are pretty easy to answer. Both ETFs and mutual funds are “investment companies” that pool money together from multiple investors to implement an investing strategy. The key differences between them lies in how they trade, how much they cost to own, and their effect on taxes.
If you’re trying to decide which one is right for you, here are the details of what you need to know.
What’s an ETF
ETFs are investment vehicles that pool money together from many investors to implement an investment strategy by building a portfolio of underlying stocks or other assets. Many ETFs such as State Street’s “SPY” have an investment strategy to track an index, the Standards & Poor’s 500 in the case of “SPY”. This way there is no chance of “picking the wrong company” by the fund’s money manager.
While ETFs are certainly the younger of the two types of funds with the first one being State street’s SPDR S&P 500 ETF Trust (SPY) introduced in the 1990s. In recent years the popularity of ETFs has soared to quickly becoming the go to means for investing by many individual investors. But why is this the case? Likely, this is due to two things, the way they trade and their cost to own.
ETFs trade like regular stocks, this means you could decide you want to buy a certain ETF at 9:45 in the morning and immediately buy the shares. Then if you decide at 3:00 in the afternoon that you don’t actually want the shares you could sell them back to the market. While the advantage of this might or might not be clear the major benefit of this is transaction liquidity for the investor.
Additionally, the annual management fee, called the expense ratio, investors pay for the money manager to keep the ETFs portfolio in check is often much lower than traditional mutual funds. This means that at the end of the year the investor is able to keep more of their gains. Over time this could become a sizable amount when compounding is taken into consideration.
We cover ETFs in much greater detail in our article about ETFs.
What’s a mutual fund
Mutual funds are actually very similar to ETFs at the core. Just like ETFs, mutual funds are investment vehicles that pool together money from multiple investors to implement an investing strategy. The vast majority of mutual funds invest in stocks, however, they can also invest in bonds, currencies, commodities, and other assets. In some cases, mutual funds allow investors access to investments they otherwise wouldn’t have access to.
Being around since the 1920s, mutual funds have been a reliable way many investors have diversified their investments. In more recent times, while still being popular, some of the ways mutual funds are structure have led to a decrease in their popularity.
One driver of the loss in popularity is due to the more stagnant way mutual funds trade. If an investor wants to buy shares in a mutual fund at say 9:45 in the morning, their order won’t be filled until around 4:00 in the afternoon. This is when the fund calculates their net asset value (NAV) in order to establish the price of the fund’s shares for the day. Likewise, if the investor wants to sell share of the mutual fund, their order likely won’t be processed until around 4:00 pm. Now it should be said for long-term investors this isn’t really a drawback because the change in value of the fund’s shares from 9:30 am to 4:00 pm on any given day will not have a big impact on their investment.
Another consideration is the management fees associated with mutual funds, called the expense ratio. Often times the expense ratio for actively managed mutual funds is higher than that of ETFs. The reason is that the investor is paying for professional money managers to go out and look for undervalued companies to invest in. If the actively managed mutual fund consistently outperforms the market then the higher fees may be worth it. But if the fund underperforms or performs just in line with the market the investor paid more for the same return they could’ve gotten elsewhere.
We cover mutual funds in much greater detail in our article about mutual funds.
Differences:
How they trade
ETFs and mutual funds trade differently. This is mainly due to the structural differences between the two.
ETFs have shares just like regular stock which trade on regular exchanges like the NYSE or Nasdaq. This is because ETFs issue and redeem stock through a process called creation and redemption. Through this process ETFs issue new shares with the help of a special investor who then sells the shares on exchanges for regular investors to buy.
Since the shares trade on exchanges, every time an investor wants to buy or sell shares of the ETF they are trading with another investor. This takes a large burden off the fund as they don’t have to be as involved with this process.
Mutual fund’s shares on the other hand do not trade on exchanges or between investors. Every time an investor wants to buy or sell shares in a mutual fund they must do so directly with the fund. Ultimately this requires more work from the fund to manage and as a result limits how often they can issue and redeem shares.
In either case, current investors aren’t exposed to dilution since both processes for share issuance for either a mutual fund or an ETF are based on NAV.
Management fees – expense ratio
Often, ETFs are much cheaper in terms of their expense ratio than actively managed mutual funds. The typical ETF expense ratio is .5% or less whereas the expense ratio for an actively managed mutual fund could be .5% to 1% or more.
The reason for the difference in price is the labor involved. With active management, the professional money managers are continuously looking for undervalued companies in line with their investment strategy to bring into the fund’s portfolio. Not only does this take a large amount of skill it also requires more analysts to be on the payroll to help find companies. As a result, the fund passes along this cost to their investors.
Passively managed ETFs on the other hand require much less work. The money manager’s job isn’t to look for stock rather just keep the fund’s portfolio in line with an index or other investment strategy.
Taxes
Given the structure of mutual funds, many face more capital gains tax ramifications than other investment forms available. When a fund manager sells a stock in the portfolio that has a gain, this triggers a capital gains tax. These capital gains tax consequences can produce an overall net negative effect on an investor’s long-term portfolio’s growth depending on their size.
ETFs rarely have capital gains tax consequences for their investors given an ETFs structure which allows them to more easily adjust higher their cost basis.
Minimum investments
Since investors must buy their shares directly from the fund in the case of mutual funds often there is a minimum investment amount required to invest. This could be anywhere from $500 to $10,000 or even higher. While this isn’t a problem for many investors with a fair amount to invest nor should it be a reason not to look at mutual funds. The minimum investment some funds require could be something an investor should take into consideration depending on their situation.
ETFs do not have a minimum investment other than whatever their shares are trading for. Since the shares trade like a regular stock, if the shares are trading for $100/share $100 is effectively the minimum requirement.
Pros
Mutual funds
- Ease of Access
- Diversification
- Professional Management
ETFs
- Ease of Access
- Diversification
- Low Fees
- Trade shares whenever you want
- No minimum investment requirement
Cons
Mutual funds
- Often expensive to own
- Trades only once a day
- Doesn’t always perform better for what you’re paying
- May have more tax consequences
ETFs
- Ease of Access – may get emotional and sell or buy at a bad time
- Possible need to pay trading commissions
Conclusion
Either choice, whether ETF or mutual fund will be up to the investor to make and will depend on their investing objectives and risk tolerance. For general stock investing ETFs have the advantage, however, for other types of investing such as income investing mutual funds may be better. Either way if in doubt a trusted financial professional may help you find what’s best for your goals.