ETFs vs. Mutual Funds: What Makes Them Different
If you’re looking to invest in the stock market, you might be thinking about investing in a mutual fund. But exchange-traded funds (ETFs) have become a popular alternative in recent years. They have many of the same benefits as mutual funds but are usually less expensive than mutual funds. Both options come with their fair share of pros and cons. If you’re not sure which is right for you, use this guide to get started.
What is a Mutual Fund?
A mutual fund invests your money across a number of different stocks, bonds and other assets, which reduces the risks associated with investing in an individual asset.
Mutual funds are usually actively managed. This means that a fund manager actively trades investments within the fund and tries to select investments to outperform its benchmark. There are two types of mutual funds, open-ended and closed-end funds. Open-ended funds are the more common of the two. With these types of funds, new shares are issued as more people buy into the fund. The price of the mutual fund is determined at the end of each day and is called the net asset value (NAV).
What is an ETF?
An ETF works like a mutual fund in that you spread your money across different investments, thus reducing the risk. Most ETFs are passively managed, with their investments tracking an underlying subset of the market, also known as an index.
Like individual stocks traded on the stock exchange, ETFs have a share price that is determined by a number of factors, including market demand and the underlying value of the assets in the fund.
ETF vs. Mutual Fund
One of the main differences between ETFs and mutual funds is their management styles. Typically, mutual funds are associated with active management and ETFs with passive management. Active management may be more appropriate for certain asset classes or if you want your investments to try to adapt with changing market conditions. Passive management may be more appropriate if you’re looking to be more hands-off and let your investments sit and weather market fluctuations over a long period of time.
While there are many thoughts on the debate of active versus passive management, it’s important to find an investment strategy that is suited for your specific goals and needs.
You should also consider the costs associated with managing your investments, commonly known as expense ratios. Actively managed funds that have professional asset management usually have higher expense ratios than passively managed funds. These expense ratios are used to pay for fund management, administrative expenses and other costs.
Some mutual funds have discounts known as breakpoints. This means that your expense ratio may be reduced if you invest larger amounts of money. Mutual funds may also come with sales charges and other commissions when you buy or sell your shares of the fund, so be sure to check to see what requirements and fees are associated with the fund before you invest.
The other major difference between ETFs vs. mutual funds is how they’re traded. ETFs, as the name implies, are traded on an exchange. This means that shares of the ETF can be traded throughout the day (during trading hours) and in real-time. Share prices of the ETF may be directly impacted by supply and demand. For example, if many people sell their shares of a particular ETF, that ETF may be seen as less valuable, and its share price may drop as a result.
On the other hand, open-ended mutual funds buy and sell shares in a direct transaction between the investor and the fund company. Unlike ETFs sold on an exchange, when an order is placed to buy or sell shares of a mutual fund, the fund company waits until the end of the day when the NAV is determined, then places the trade.
Capital Gains Tax
These two options also differ in terms of the way they are taxed. ETFs tend to be more tax-efficient than mutual funds. The investor usually doesn’t have to pay a capital gains tax unless the shares are sold for profit.
Actively managed mutual funds can incur capital gains tax due to the way they are structured. The fund manager may buy or sell investments within the fund. When investments are sold for a gain, the capital gains tax will be passed on to everyone who owns shares of the fund, even if you never sold your shares.
Funds may require you to invest a certain amount of money to get started. Some mutual funds may have investment minimums that can range from hundreds of dollars for beginner funds, to tens of thousands of dollars for more advanced funds. There are some mutual funds that don’t require a minimum investment. However, they may have other requirements like holding the fund for a certain period of time. If you sell your shares before then you may be charged a fee.
ETFs may be more accessible because you can buy them on an exchange with the minimum amount being the cost of one share. Some investment brokerages allow you to trade fractional shares, which means you may not even need the total cost of one share to invest in the ETF.
Which is Right for You?
There are lots of different factors to consider when signing up for an ETF or mutual fund. Consider your investment goals and investment timeline before investing in a fund or asset. If you’re looking for something that tries to adapt to and outperform the benchmark, an actively managed mutual fund may be a suitable choice. If you want to match the performance of an index for lower costs, an ETF may be more suitable.
For more information on investment products and how they can help you achieve your financial goals, talk with one of our CFS Financial Advisors1 and Ent Credit Union.