For every investor, there is always a difficult decision to make when choosing between arrays of choices such as bonds or stocks, value or growth, domestic or international, and many others. We all have been there once, and so we understand how daunting a task it can be deciding whether or not to invest in a mutual or exchange-traded fund (ETF). But this can be simpler than you imagine if you understand the fundamental differences between the two types of funds and how they can both affect how much money you make buying them and how to make the money.
What Are Exchange-Traded Funds (ETFs)?
These are the types of funds that trade on exchanges exactly the same way stocks do. By this, you have the fund manager, yourself, and another investor on the other side of the trade (who is in the business just as you are. You’re free to buy and sell funds during a trading session and at the price which is always determined by the market conditions.
In other words, this means you don’t have to wait till the end of the day before trading in funds and there is no limit as to the holding period.
One of the most interesting things about ETFs (and, of course, a key difference between ETF and mutual funds) is the tendency to reflect the new market reality faster than mutual funds.
Another key factor that differentiates ETFs and mutual funds are the fact that ETFs are index-tracking. By this, it means ETFs match the price movement and the returns of an index. This, they do by closely assembling and matching a portfolio with the index constituents.
One of the good things about Exchange-traded funds is that it has passive management, which makes it cheaper. Aside from this, index-tracking ETFs are less expensive when compared to index-tracking mutual funds.
Another good thing about ETF funds is about its structure and tax efficiency. By this, ETFs are structured in a way that makes it more tax-efficient than mutual funds. As an investor buying either ETFs or mutual funds, you’re taxed every year based on the gains or losses you make from portfolios. This means the more trading you engage in the more tax events you have. But the good about ETFs is that they engage in less internal trading, which creates fewer taxable events for you when you trade in ETFs.
All in all, if you invest wholly in an ETF portfolio, tax issue will only arise when there is selling and buying of shares by you.
What Are Mutual Funds?
How mutual funds is that when you invest in it, your transaction is being managed either directly by a company other than you or through a brokerage firm. Companies such as BlackRocks, the Vanguards, etc. are good examples here.
Unlike in the ETF where you can buy and sell any moment during the trading session and at whatever price in the market, when you buy a mutual fund the purchase is calculated at the net asset value of the fund based on its price at the close of the market that day or the next depending on whether your purchase is before or after the close of the markets.
The same process your purchase is executed, exactly the same way your sale of shares is treated but in a reverse way. But again, the thing is you may not want to go into the trading too early as some mutual funds assess a penalty.
As for the index-tracking Mutual funds, active management is involved. This means people who manage the funds choose arrays of holdings so as to beat the index against which their performance will be measured. In most cases, this can be very costly as actively managed funds required spending on things such as analysis, researching the economic and industry trends, visiting companies, among many others. All these are one of the reasons while the mutual fund is expensive to manage when compared to ETFs.
Things Common To Both ETF and Mutual Funds
While there are some differences between ETFs and Mutual funds, here are some areas of similarities between the two types of funds:
- Both ETFs and mutual funds involve holding portfolios of stocks and/or bonds
- Both are capable of tracking indexes.
- Both are open-ended. By this, it means you’re allowed to adjust the number of outstanding shares either up or down depending on the response to supply and demand.
Differences Between Mutual Funds and ETFs
Although there are several differences between mutual funds and ETFs, below are the key differences between mutual funds and ETFs:
- While the timing of trade settlement for mutual funds is at the end of the day, ETFs timing of trade settlement is intra-day. Here what this means for trading in mutual funds is that the price at which you buy or sell a mutual fund is executed based on the net asset value and not the actual price at which you buy or sell the funds. In contrast, buying and selling of ETFs is intra-day, which is like stocks.
- In ETFs, you’re allowed to make stock or market orders. This helps in avoiding risks such as pricing and behavior associated with day trading. In contrast, this opportunity doesn’t exist in mutual funds.
- The expense ratios are lower in ETFs than in most mutual funds.
- While most ETFs are passively managed, mutual funds are either passively-managed or actively-managed.
So you’ve read all there is to differentiate between exchange-traded funds and mutual funds, and so you shouldn’t go wrong deciding which one to invest in. As you about to take the plunge, read over this article and consider what each type of fund offers carefully so you’d be able to see which one is best for you.