As an investor, you are tasked with understanding the different investment vehicles available in order for you to be able to make well-informed decisions. Each asset class and investment type has its pros and cons, and it is knowing those pros and cons that will help you navigate the investment world with confidence. When it comes to funds, there are two primary investment vehicles that investors flock to: ETFs (Exchange-traded funds) vs Mutual Funds.
While the two have a lot of similarities, they also have noticeable differences. It’s a good idea to know the key differences rather than getting caught up in the granular details. After reading this article, you will have a clear understanding of the mechanics behind ETFs and Mutual Funds, along with some of their key differences.
Before we continue, Financial Professional wants to remind you that this article is educational in nature. Any securities or firms named are for illustrative purposes only and do not constitute financial advice. Always do your due diligence and consider your situation – and the help of a licensed financial professional – when making investment decisions.
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An Exchange Traded Fund (ETF) is a fund that you can purchase on an exchange which tends to mirror the performance of a particular sector, asset class, country, etc.
While there is a handful of active ETFs, the majority of ETFs are passive in nature. “Passive” means that the fund is designed to provide you with the same performance as the underlying investment(s) owned by the fund.
For example, SPY is a well-known ETF that tracks the performance of the S&P 500. Because SPY owns the same stocks in the S&P 500 index, in equal proportion to the index, you will experience the same level of gains and losses as the index. In other words, if the S&P 500 is up 10% and you’ve held SPY over the same time period, you should expect your gains to be up 10% as well.
ETFs are very popular because the majority of them are cheap to own and trade just like stocks.
For example, consider VOO, which is Vanguard’s S&P 500 ETF. VOO has an expense ratio of 0.03% or 3 basis points. That is very, very cheap for a fund of any kind.
Why is it so cheap? Vanguard is not trying to provide you with alpha, or excess returns, with this fund. The only objective is to provide you with the exact same performance as the S&P 500. If the fund mirrors the returns of the index perfectly, it is doing its job. Because less work goes into mirroring an index, the fund is offered at a very inexpensive cost.
When you are looking to trade an ETF, you have to be mindful of the bid and ask spread. As a reminder, that is how investments are quoted when they are listed on an exchange and can be traded through a broker. The spread is the difference between the ask (the lowest price that you can purchase an investment at) and the bid (the highest price that you can sell the investment for). For example, if an ETF is quoted at $55.05 bid/$55.10 ask, the spread would be $0.05.
Depending on how liquid the fund is, the spread may vary. Funds that are more actively traded than others tend to have thinner spreads than funds that are less actively traded.
For those new to the ETF game, there are a few more key details of which to be aware:
A mutual fund is very similar to an ETF in that it is offered and managed by an investment company. However, there are several notable differences. First, let’s describe what a mutual fund is.
A mutual fund is a fund that is offered by an investment company, which manages the fund. Mutual funds are managed by a team of professionals, according to a specific strategy. For example, the DODIX fund offered by Dodge and Cox is a mutual fund that is designed to preserve principal while providing investors with income via fixed income securities and cash equivalents.
As a shareholder of the fund, you directly participate in the performance of the fund, depending on how well (or poorly) the mutual fund is managed.
Mutual funds can be active or passive, like ETFs. However, most mutual funds are known to be active in nature. This means the management team is actively looking to provide shareholders of the fund with excess returns (alpha) compared to a specific benchmark, like a sector. Because extra work goes into running an active mutual fund, these funds tend to come with higher internal expenses.
A mutual fund is also required to pay out capital gains distributions to its shareholders. This means that shareholders receive proceeds from the trades made by the fund manager, and have to pay capital gains tax on those proceeds. Again, if you are tax-sensitive, you may want to consider owning mutual funds in a tax-deferred account, such as a 401k or an IRA, to avoid the current taxation of these distributions.
The process behind trading mutual fund shares also can vary compared ****to ETFs. The first thing to consider is whether the fund is closed-ended or open-ended.
Open-ended funds only trade at the close of the trading day, when the Net Asset Value (NAV) of the funds is calculated. If you own open-ended funds, they will trade at this Net Asset Value at the end of the day.
When trading an open-ended fund, you will buy shares directly from the mutual fund company and sell them directly back to the company. The process of selling your shares to the fund company is referred to as “redemption”. Because you are dealing directly with the fund company, there is no bid/ask spread when purchasing or redeeming open-ended fund shares.
Notice how this is different from ETFs, which tend to trade on the secondary market.
There are also closed-ended mutual funds, which trade on the secondary market and are not necessarily trade at the fund’s NAV.
Mutual funds also tend to carry sales loads, which are commissions paid by the investor when purchasing shares of a mutual fund. The commission itself depends on what is known as the share class. It is recommended you research these commissions more in-depth prior to purchasing or selling mutual fund shares, but for a quick breakdown:
Some of the most notable similarities between ETFs and Mutual Funds include:
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Some of the key differences between mutual funds vs ETFs include:
Whether you own strictly ETFs, mutual funds, or a combination of the two, you can still be successful as an investor. The key is to have a clearly defined strategy that you stick to consistently.
Remember, each investment vehicle has pros and cons. There is no one investment vehicle that is always going to be superior to another. While active mutual funds have been criticized for their inability to outperform their benchmarks, there are still funds out there that perform very well. And, while ETFs are known for being cheap, there are still funds out there that are unnecessarily expensive.
It’s important to do your due diligence in research to understand the costs and risks associated with any specific investments you add to your portfolio. It’s also crucial that you keep in mind not only your financial goals but your personal circumstances as well.
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