Investing in the stock market is appealing, but it comes with risk because stock prices change rapidly. Often, you need to stay on top of stock movements and be really knowledgeable about all the stocks you’re choosing if you want to come out of it with a profit.
ETFS and Mutual Funds: What’s the Difference, Anyway?
For people who want to invest, but don’t want to do the work of deciding which individual stocks to invest in and keeping on top of fluctuations in stock prices, there are other options. Two of the most popular ones are ETFs, and mutual funds.
They are both ways to invest in a broad range of stocks without the headache of picking each one yourself or actively managing your investments. You get a more diversified investment with a mutual fund or an ETF than if you invested in just one or two stocks. But they have their differences.
It’s not always clear what distinguishes ETFs from mutual funds, or which one you should choose. I’m going to explain the basic differences between ETFs and mutual funds so that you can pick the one that best suits your situation.
What Is a Mutual Fund?
A mutual fund is a professionally managed investment fund that pools money from many investors to purchase securities.
When you invest in a mutual fund, you transfer your money to the manager of the fund – the bank or investment firm – and you purchase shares in the fund according to the net asset value of the fund based on its price when the market closes that day, or the next day if you place your order after the close of the markets.
A mutual fund spreads the investor’s risk over a range of companies, but can only be traded at the end of the day, according to the end-of-day asset price.
Some mutual funds track indexes but most are actively managed. They often use the expertise of analysts and industry researchers to try to beat an index against which they are measuring their success. This approach can bring results, but it also brings higher administration fees.
What Is an ETF?
ETF stands for an exchange-traded fund. When you invest in an ETF, you’re buying a basket of securities and equities that trades on the stock market. An ETF can be a passively or actively managed investment.
If it is actively managed, then the company that manages the ETF will make decisions about what stocks to buy or sell from the fund. If it is passively managed, then it will track an index and will hold stocks in the same ratio as found in the index.
Often these indexes are rules-based, meaning that they are transparent in the way they select companies for the fund, and prospective investors can consider whether the rules will result in companies they support or believe will be successful in the ETF.
An ETF can track a commodity, like gold ETFs; an industry, like a clean energy ETF; a theme like a SPAC ETF, or even an index fund.
Unlike mutual funds, the ETF can be bought and sold like a stock itself. The price of an ETF changes constantly throughout the day, and you can trade in ETFs just like you can trade in other stocks.
The main differences between ETFs and mutual funds
1. Tradeability
You can trade ETFs throughout the day, but mutual funds can only be bought or sold once a day. You can see how much an ETF is worth (its net asset value, or NAV) by tracking the changing price throughout the day.
With mutual funds, the manager calculates the NAV once, when markets close. You won’t know the price until after they make their calculations.
However, both ETFs and mutual funds are intended for long-term investing, not rapid trading. If you’re investing long-term, you likely won’t need minute-by-minute price changes.
You can leave a mutual fund whenever you like because the manager just buys back your share. But to leave an ETF, you have to sell it to somebody. If the ETF is doing badly or there’s no interest in your sector, you might find it tough.
That’s why you should check the trading volume of an ETF. The higher the trading volume, theoretically the easier it will be to sell.
2. Investment Minimum
The minimum amount that you will need to invest in an ETF is the cost of one share plus fees and commissions. This could be as little as $10. Some mutual funds do not demand a minimum investment, however, many ask for at least $500 to $5,000
Tax Efficiency
If you make a profit on your investment, you’ll need to pay capital gains tax, unless you’re using a tax-efficient vehicle like an IRA or a 401(k). ETFs and mutual funds calculate capital gains tax quite differently.
When you sell an ETF, you sell it to another investor who pays you directly, and then you pay the tax you’ve incurred on your investment. The ETF-issuer does not sell any stock in order to pay you for your share.
As a passively managed portfolio, ETFs, therefore, realize fewer capital gains than actively managed mutual funds. This can have tax implications for investors.
In contrast, consider the example of an investor selling their $10,000 position in a mutual fund. The fund will sell $10,000 of stock in order to pay the investor.
If the stocks have risen in value, then the fund realizes a capital gain, which is distributed to the shareholders at the end of the year. This can happen multiple times and results in the shareholders paying tax on the turnover within the fund.
These differences may not result in very large differentials in tax implications, but they are worth bearing in mind when choosing between an ETF and a mutual fund.
Fees
When it comes to fees, you’ll need to check the details on each ETF or mutual fund that you are considering. Mutual funds tend to have higher fees as they are usually actively managed. However, there is no iron rule and it’s best to read the small print.
Fees are often expressed as an expense ratio, which tells you how much you’re paying per $100 invested. For example, an ETF with an expense ratio of 0.05% costs you 5 cents for every $100.
Some brokers charge commission whenever you buy or sell an ETF. Some mutual funds charge a penalty if you sell before a defined time.
So Which Should You Choose, an ETF or a Mutual Fund?
You probably want to know which one is better, but I can’t really tell you. Much depends on what you want to achieve.
If you want to trade stocks, ETFs might be a good choice. You can actively trade them and set buy and stop orders just like on individual stocks, but you’ll have a more diversified portfolio while you’re at it.
However, if you are really risk-averse and you just want your money to sit for the long term, you might prefer a mutual fund.
People who have only a small amount to invest also usually choose ETFs. They are seen as more accessible than mutual funds, and small investors appreciate being able to easily buy and sell them.
Conclusion
Finally, because of the way that ETFs are structured, they are generally more tax-efficient, making them the choice of people seeking to minimize their tax burden. But again, if you’re using 401(k) or an IRA, that may not be an issue.
The decision is in your hands. The Funds’ investment objectives, risks, charges, and expenses must be considered carefully before investing. The prospectus contains this and other important information about the investment company.
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