Every savvy investor knows investing in a fund is hands-down one of the best ways to diversify your portfolio. But which is better: a mutual fund or an exchange-traded fund (ETF)?
Sure, both mutual funds and ETFs give you broad market exposure at an affordable cost. But beyond diversification, ETFs and mutual funds have profound structural differences that affect how you buy and sell them, how much you pay in taxes, and how much you’ll owe in fees.
Let’s look closer at mutual funds and exchange-traded funds to see which one fits your investing strategy better.
What is an Exchange-Traded Fund (ETF)?
An exchange-traded fund (ETF) is a basket of investments (such as stocks, bonds, or commodities) that you can buy or sell during normal trading hours. ETFs usually follow an index, such as the S&P/TSX, or they track certain industry sectors and foreign economies.
What is a Mutual Fund?
A mutual fund is an actively managed basket of investments that you can buy or sell at the end of the trading day (more on this below). Mutual funds give investors the chance to pool their money together and buy stocks, bonds, and other assets in multiple companies.
How are ETFs and Mutual Funds Similar?
As you can see, ETFs and mutual funds aren’t worlds apart. In fact, ETFs and mutual funds were created to solve a similar problem: how to help hand-ons investors diversify their portfolios without the pain of hand-picking investments themselves. For that reason they share many traits, including the following.
1. They help you diversify
Both ETFs and mutual funds allow you to invest in a broad range of companies, many of which you probably wouldn’t have known beforehand. If you don’t have time to pick individual stocks, ETFs and mutual funds can give you market exposure at a lower cost.
2. They’re overseen by fund managers
Every fund has a fund manager, someone who oversees its performance, rebalances it, and ensures it hits its investment objectives. Fund managers also own the investments inside the fund: when you invest with one, you own a share of the fund, but not the investments themselves.
3. They have expense ratios
As great as a diversified basket of investments sounds, they’re not free: you’ll pay an expense ratio to own them. The expense ratio is simply all the annual operating fees in a fund expressed as a percentage. For instance, if you bought a mutual fund with a 1% expense ratio, you’d pay $10 a year for every $1000 you invest.
How are ETFs and Mutual Funds Different?
Mutual funds have been around since the 1920s, and they’ve survived a great depression, two world wars, and enough recessions and corrections to make even Warren Buffet break a sweat. ETFs are younger (circa the 90s), but their quick rise to fame has given mutual funds a run for their money. Here’s how the two funds are different.
1. Mutual funds are actively managed
ETFs and mutual funds both have fund managers, sure, but their management style is different: mutual funds have active management, whereas ETFs are passively managed.
Active management means your mutual fund manager (often a team of investment professionals) is trying to outperform the market. They don’t want to match the market (like an ETF does): they want to beat it. Their job—their career—is to predict how the market will behave, buy and sell investments in response to it, and help you get extra gains.
ETF managers, on the other hand, want to track an index market, rather than beat it. They may buy and sell investments to rebalance the portfolio, but they’re not trying to get short-term gains.
Which is better: active or passive management?
Active management can be valuable during an economic downturn, when proactive management is more important than market imitation. But the opposite can be true, too: your mutual fund manager may make decisions that cause your fund to underperform the market.
While ETFs will never outpace the market, passive management allows them to grow steadily over time. In fact, over the long-run, most ETFs outperform actively-managed mutual funds simply because mutual fund managers can’t beat the market every time.
2. Mutual funds have higher fees
Having an investment expert on your team is great, but don’t think that expert is running a charity: no financial expert works for free. In fact, one of the biggest drawbacks to mutual fees is that, well—they’re pretty dang expensive.
The fee you pay to your mutual fund manager is called a load, which is basically jargon for “sales commission.” You’ll pay two loads: first, when you buy your mutual fund (called the “sales load”), then when you sell it (called the “back-end load”). On top of that, you’ll also pay the expense ratio—the annual operating fees—which are typically higher with mutual funds.
In comparison, ETFs are significantly cheaper. For one, they don’t have loads, and their expense ratios are very low. You won’t have someone managing your portfolio, but you also won’t be paying them, either.
3. ETFs trade like stocks
ETFs are bought and sold on an exchange (hence the name). Unlike mutual funds, ETFs can be traded throughout the trading day, and their prices are set by supply and demand. Of course, you’ll pay a commission for each trade you make, not to mention risk losing out on long-term growth, but an ETF’s trading flexibility gives you more day trading freedom.
Mutual funds don’t trade on an exchange. Instead, you have to wait until the end of the market day (usually 4pm EST). Also, keep in mind—the price you buy and sell a mutual fund isn’t set by supply and demand. Rather it’s the net asset value—the fund’s total assets minus liabilities—which fund managers calculate at the end of the trading day.
But ETFs aren’t the golden child here—because you buy ETFs through a brokerage, you’ll pay your broker a commission for each trade you make. While commissions are typically low, they can add up if you trade frequently.
4. Mutual funds incur more capital gains taxes
To understand what this means, let’s return to a mutual fund’s biggest strength—active management. Because your fund manager (if they’re proactive enough) is trying to beat the market, they’ll also buy and sell investments within the fund more frequently. When they sell an investment for a gain, you get a piece of the earning (your dividend).
That’s great, right? Sure. But getting gains also means you have to pay more capital gains taxes (whomp, whomp). When a manager sells for a gain, every fund holder pays a portion of the capital gains tax, which, depending on how often your manager trades, can start to add up.
An ETF, on the other hand, tracks an index, so fund managers are far less likely to sell investments. More often than not, you’ll only pay capital gains taxes when you sell your ETF on an exchange, if you get a gain, that is.
5. Mutual funds have higher minimum investments
Mutual funds can have a steep barrier to entry: often you’ll need around $1000 to $5000 to open a mutual fund (some mutual fund managers will lower the barrier, especially if you agree to invest on a regular basis). ETFs, on the other hand, don’t have minimum investments, or, if they do, they’re not steep.
When is an ETF Right For You?
If you want more trading flexibility, or you want to employ different trading strategies (stop orders, short selling, or limit orders), ETFs might be right for you. Passive management can help you earn more in the long-run, especially if you “set-it-and-forget it”, and you might enjoy lower capital gains taxes, expense ratios, and no load fees.
Just be careful of commission creep: every trade you make means you’ll pay a trading commission, which can start to add up.
When is a Mutual Fund Right For You?
If you’re not interested in day trading, and you want someone to actively manage your fund, you might be better off with a mutual fund. Having an active fund manager not only means you could outperform the market, but you could also lower the risk of losing money in a market downturn.
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