When it comes to investing, most retail investors are familiar with the idea of buying and selling stocks on the stock market.
Many investors choose to put their investments on autopilot, which they often do by investing in mutual funds.
However, ETFs present an attractive option for long-term growth and short-term trading opportunities.
ETF vs Mutual Fund: 4 Key Differences
1. Management
2. Investing Minimums
3. Trading Process
4. Taxes
Mutual funds have been around longer, and are more well known as an investment option than the exchange-traded fund shares sold on the stock exchange.
A mutual fund basically involves multiple investors pooling their cash together to invest in a selection of securities (and sometimes other asset classes) under the direction of a portfolio manager. This allows an individual investor to purchase a wider array of stocks than they would normally be able to.
It may also offer access to a more complex investment strategy than simply buying and holding or buying and selling stocks. Sometimes the fund manager will leverage derivatives, like options on underlying assets, in order to increase the capital gain of the mutual fund.
An actively managed mutual fund will often lay out its strategy, and of course, its holdings, in the fund’s prospectus provided to shareholders. Investors do have to participate in mutual funds by purchasing individual shares. The share price of a mutual fund is determined by calculating its net asset value. However, most mutual funds let investors purchase fractional shares. This allows investors to contribute a fixed dollar amount to their mutual fund of choice on a regular basis, rather than only buying shares when they have exact change, so to speak.
As such, it’s easiest to think of mutual funds as an investment where what you get out of it is proportional to the dollar value you put in. ETFs stand for exchange-traded funds. These are similar to mutual funds in that they may represent a broad basket of investments, however, ETFs usually follow a particular index— whether that index is fairly broad, such as the S&P 500, or fairly specific, such as companies that produce lithium batteries.
Shares of the ETF are bought and sold on the stock market throughout the day, just like any stock, making ETFs a fairly liquid investment. For investors with lower risk tolerance, an ETF is an investment vehicle that allows them to experiment in a promising industry without putting all their eggs in one basket.
ETFs do not necessarily pay dividends—it largely depends on if it contains stocks that do. If an ETF is focused on dividends, though, it can be a great investment vehicle for passive income if your investment objective is fixed income.
ETF vs Mutual Fund Similarities
ETFs and mutual funds represent a diversified portfolio of holdings, usually around a particular theme, industry, index, investing strategy.
They do not represent a single company, but rather a group of companies that have been invested in using the pooled money provided by investors who have purchased shares. ETFs and mutual funds both have share prices, and both are available to retail investors as investment vehicles.
Both ETFs and mutual funds are a way to minimize the risk of putting all your proverbial eggs into one basket. But that’s about where the similarities end because there are many key differences between the two.
ETF vs Mutual Fund: 4 Key Differences
1. Management
Once you take a closer look, you see that mutual funds and ETFs are actually quite different. Mutual funds are often very actively managed.
The portfolio manager or managers are like captains of a merchant ship, sailing from port to port, picking up certain goods (that is, stocks, corporate bonds, government bonds, commodities, and derivatives), and unloading others based on market research.
This also means that they can throw other asset classes into the portfolio, such as cash, precious metals, or even bonds. ETFs, by contrast, are mostly on autopilot—automatically following a group of stocks or an index. ETFs dedicated to an index or certain group of stocks will not usually have other asset classes in the mix to balance out their performance.
However, there are ETFs that are dedicated to certain asset classes, such as precious metals. There are mutual funds that function similarly to an index fund. Such a passive fund might have a lower expense ratio (that is, lower management fees), but it might be less competitive than an active mutual fund.
Whatever the case may be, a mutual fund is usually managed by a financial advisor or advisors and represents a more complex investing strategy that can (ideally) show greater returns.
2. Investing Minimums
While it’s true that some mutual funds have low or no participatory fees, most mutual funds will charge at least $500 or $1,000.
There may also be rules about the minimum amounts that can be leveraged to purchase additional shares (that is, how much you must contribute periodically). In a similar vein, a hedge fund is a type of mutual fund open only to accredited investors—basically only people who either make $200,000 annually or who have seven figures in assets, excluding their personal residence.
By contrast, an ETF’s only minimum is its share price. Whether you can buy one share, 10 shares, or 100 shares, it really all comes down to how much cash you have and the price of the ETF. Other than that, there are no minimums.
Some apps, like Robinhood, even allow you to purchase fractional shares of an ETF. So, for instance, if you only have $1, but want to purchase into an ETF with a share price of $45, you can still do so by buying 1/45th of a share.
The advent of fractional investing has allowed many retail investors to buy into ETFs, and it’s likely that mutual funds will soon find a way to make fractional investing more accessible to potential investors—otherwise, they stand to lose business to the competition.
3. Trading Process
Mutual funds can only be bought and sold at the end of the day. This means that no matter when you placed your order, whether it was just 10 minutes before the close of trading or right when the market opened that morning, your shares will be bought and sold for the price that’s currently relevant at the close of the day.
And, as mentioned earlier, that price is calculated by taking the net asset value of the mutual fund into consideration. Remember that mutual funds do not just have stocks and bonds among their underlying assets—they may also have cash, precious metals, commodities, and other investments.
This means that the share price for a mutual fund is not just calculated by factoring in the stock prices in its portfolio. There needs to be some accounting, which only allows mutual funds to calculate their share price once per day. By contrast, ETFs can be bought and sold at any time. There are even some apps that allow you to buy or sell shares of ETFs after hours when the market is closed.
The price of ETF units is also calculated using the net asset value, but since ETFs typically don’t have underlying assets other than stocks and cash, the net asset value more closely resembles the sum of its components.
In fact, while mutual funds are not required to disclose their holdings on a daily basis, ETFs are—which means that an ETF shareholder or potential shareholder enjoys greater transparency about its pricing, which may make ETFs a more attractive option for certain investors.
4. Taxes
Mutual funds involve a lot of active management, and that means buying and selling stocks and other assets that could trigger taxable events.
As such, the holder of mutual fund shares is going to see their investment rocked taxes a lot more than someone holding shares of an ETF. With an ETF, the only taxable event is going to be the sale of the ETF shares, which could trigger capital gains taxes.
This is one reason why, in terms of short-term investments, ETFs might be a better alternative. Moreover, if ETFs are traded inside of a tax-deferred or tax-sheltered account, like a Roth IRA, you won’t have to pay capital gains taxes.
However, an investor might prefer to buy and sell stocks and ETF shares inside a brokerage account, because even though they have no tax advantage, they do offer more trading flexibility.
Do you have tax questions about ETFs or mutual funds? Join our Tax Tuesday Webinar for your chance to ask the Anderson Advisor’s tax experts!
Is an ETF or Mutual Fund Better?
A mutual fund is a great option for retail investors who have several decades to consistently allocate a portion of their paycheck into a managed investment.
Over time, depositing five to 10 percent of your paycheck into a mutual fund suggested by your employer can really snowball into some serious net worth, especially if the company matches your contribution.
However, for traders who are more active or have some sense of what they are doing, ETFs might be a better option because there are fewer fees and taxable events to eat away at gains, and the ETFs themselves are easier to liquidate in a trade.
Keep in mind, however, that unless the ETFs are bought and sold in some sort of tax-sheltered, account like a self-managed IRA, realizing an overall profit from the sale of your assets can trigger capital gains taxes.
ETFs and Mutual Funds Are Both Great Investments, It Just Depends on Your Investing Style
ETFs and mutual funds are both baskets of investments, and you can participate in either by purchasing shares.
But while ETFs can be traded whenever, mutual funds can only be traded at specific times. Mutual funds are also actively managed and may involve multiple asset classes, whereas ETFs are dedicated to one index or asset class and follow it on autopilot.
