ETFs vs Mutual Funds: What’s the Difference?
Exchange Traded Funds, or more commonly referred to as ETFs, and mutual funds are a popular choice for investments. There are many similarities between the two, however, there are also some key differences. ETFs vs mutual funds, which is right for your portfolio? Let’s look at the significant features of each.
Popularity of ETFs vs Mutual Funds
Most company 401(k) plans and other company sponsored retirement plans have ETFs or mutual funds for their employee’s investment choices. In addition, many DIY investors will use ETFs and mutual funds instead of, or in addition to, investing in individual stocks or fixed income instruments in their portfolios.
At the end of 2023 there was $8.1 trillion net assets invested in ETFs and $17 trillion net assets invested in mutual funds which are based in the US. However, the overwhelming trend over recent years has been for ETF inflows and mutual fund outflows due to a preference for lower costs, more tax efficiency, and a trend toward passive investment management which is obtained through ETFs.
ETFs vs Mutual Funds – Similarities
Portfolio Diversification
ETFs and mutual funds both offer broad portfolio diversification through buying just one security. Both enable an investor to invest in a basket of securities, for example stocks or bonds. The ETF or mutual fund will typically have a mandate to invest in a specific type of security, such as large US companies, emerging markets, or the mandate can be as narrow as investing only in companies which focus on pet care and pet food products, as an example. The less diversified the ETF or mutual fund holdings are, the more volatility the ETF or mutual is likely to experience.
To reduce portfolio volatility even more, a combination of ETFs and/or mutual funds can offer exposure to a wide variety of asset classes and niche markets, allowing for even more diversification benefits than would be possible by using just one ETF or mutual fund.
Management Style
ETFs and mutual funds can both be either be actively managed, passively track an index, or a blend of both portfolio management strategies. However, most mutual funds are actively managed and most ETFs are passively managed.
Typically active management comes with a higher expense ratio charged for the security, and conversely passive management allows for lower expense ratios. But it is important to fully understand all the costs associated with any investment. To learn more about some hidden expenses associated with passively managed index funds, read more here.
ETFs vs Mutual Funds – Differences
ETFs and mutual funds differ in some significant ways. One isn’t necessarily better or worse than the other, but understanding the differences will help you make the best selection for your situation.
ETFs vs Mutual Funds – Trading Differences
ETFs trade like stocks that are bought and sold on a stock exchange, experiencing price changes throughout the day. This means that the price at which you buy an ETF will likely differ from the prices paid by other investors because of timing differences. In contrast, mutual fund transactions are executed once per day by the mutual fund company, with all investors on the same day receiving the same price.
ETFs vs Mutual Funds – Minimum Investment
Because they trade like stocks, ETFs don’t have a required minimum investment and are purchased as whole shares. You can buy an ETF for the price of one share, usually referred to as the ETFs market price. The minimum initial investment for mutual funds are normally a flat dollar amount and aren’t based on the fund’s share price. Unlike ETFs, mutual funds can be purchased in fractional share or fixed dollar amounts.
ETFs vs Mutual Funds – Costs
ETFs have both implicit and explicit costs. The ETF provider will disclose the operating expense ratio, but there are other costs involved such as the bid/ask spread and premium/discount to net asset value. The bid/ask spread refers to what one share of the ETF will sell for in the marketplace at a given moment compared to what someone is will to pay for it at the same time. The premium/discount to net asset value refers to the current market value of one share of the ETF compared to a pro-rata value of the underlying holdings inside of the ETF. They may or may not be in synch with each other depending on market prices at any given time.
In contrast, mutual fund are priced at the end of the day by calculating the value of the holdings within the mutual fund at the close of the markets and allocating that value across the mutual fund shareholders. However, mutual funds may have additional expense which may not be obvious such as sales loads or early redemption fees.
ETFs vs Mutual Funds – Tax Efficiency
ETFs typically generate fewer capital gains for investors for a couple of reasons. ETFs may have lower turnover for their holdings due to their more passive management style which will reduce trading costs and market inefficiencies. ETFs can avoid transactions which would incur capital gains because ETFs don’t need to buy and sell all of their holding in the market place. Instead, ETFs can use the in-kind creation/redemption process to manage the cost basis of their holding and this option isn’t available to mutual funds.
A sale of securities within a mutual fund may trigger capital gains for shareholders. It may come as a surprise for mutual fund investors because the investor could potentially have an unrealized loss on their mutual fund investment, but they may still receive a 1099 tax form with a taxable capital gain from sales of holdings withing the mutual fund.
ETF vs Mutual Fund – Which is Right for You?
As with all things in investments and financial planning, it depends! If you trade actively or being able to trade during the day at the current share price is important, then ETFs may be a better choice for you. If tax efficiency is important, than an ETF may be the better choice. If your investment is held in a tax-qualified account such as an IRA, tax efficiency may not be as important. If a low expense ratio is important and you don’t believe active management is worth the additional expense associated with it, than an ETF may be a better choice for you. However, be sure to look under the hood for all the associated expenses to determine the true cost of the investment.
Additional Information:
As always, if you would like more information on ETFs and mutual funds, or any other financial planning topic, please contact me. Find out more about Access Financial Planning, LLC here
Disclaimer: This article is provided for general information and illustrations purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult with a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Tricia Rosen, and all rights are reserved. Read the full disclaimer.