If you’re starting out with investing or selecting investments for your IRA or 401(k), you’ve probably looked at a number of fund options. You’ve probably also come up against a basic distinction: ETFs vs mutual funds. The terminology can be confusing but the differences can be important.
Let’s take a closer look.
What’s the Difference?
Both are funds. “ETF” stands for “exchange-traded fund,” and of course, a mutual fund is also a fund. This means that the managers in both instances pool investor money into one big chunk and buy a wide variety of stocks or bonds. That way, if one asset decreases in value, the others may make up for it by increasing in value.
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Funds allow you to hold a diversified range of investments even if you have a relatively small amount of money to invest.
But if both are funds, why do we need both ETFs and mutual funds? Isn’t a fund a fund?
They actually have significant differences that may be important to you.
This investment is a portfolio actively managed by a fund manager or management team. That means they will make buy and sell decisions on a constant basis to try and improve performance. Their goal is to do better than the general market.
So, for example, the fund might sell Tesla stock and purchase Google stock if they think it can make more profit.
ETFs are passively managed. The fund typically contains assets that match an index, such as the S&P 500, Nasdaq, or emerging market indexes. The goal here is not to outperform the market, but to match it. The fund buys and sells assets to keep the correct mixture to match the index accurately.
This is called “passive” management because the managers simply follow what the index contains.
As an example, SPY, an ETF that tracks the S&P 500 index, will buy assets that are in the index and sell those that belong to companies that are no longer in the index.
Advantages and Disadvantages
The different approaches of ETFs vs. mutual funds have important implications for you.
Mutual fund managers are actively involved in selecting and trading stocks. That typically means higher expenses. Those expenses come out of your money.
Does that mean you should automatically choose an ETF? Not necessarily.
A mutual fund tries to beat market returns; an ETF tries to match market returns. If you think a mutual fund can do better than the market, the extra expense could be worth it.
When You Can Trade
This is one of the most significant differences. You buy or sell ETF shares at any time during the trading day. When you sell shares of a mutual fund, you don’t know the price until after the market has closed.
If you see ETF shares tumbling, you can sell and get out immediately. If mutual fund shares tumble, you can sell, but your transaction won’t occur until the end of the trading day, and you have to accept the closing price. In short, you can’t get out of a mutual fund quickly.
Similarly, you can buy an ETF if it is surging upward, but if you were to buy a mutual fund at the same time, it could rise all day, and you would only get the closing price–and miss out on the day’s rise.
Your investment style can help you choose which approach is best for you.
A mutual fund could work if you plan to buy and hold for a long time because you won’t be buying and selling every time the market rises or falls.
If you want the ability to exploit or defend against rapid price movements, an ETF might be your preferred choice.
Mutual funds often have a minimum you must put in. Typically, this is $1,000, though some only require $500.
There is no minimum on an ETF – you can buy one share if you want to. Some online trading platforms allow you to buy a partial share.
If you want to “dip your toe in the water” by purchasing small amounts, an ETF works well. You’ll need to have a larger sum of money to invest if you want to consider mutual funds.
ETFs typically contain the same assets that an index follows.
For example, an ETF may track the S&P 500 index, the Dow Jones Industrial Index, or the NASDAQ. There are also numerous smaller indices, and many of them have ETFs tracking them.
You can buy ETFs tracking the entire market (the Wilshire 5000 index). You can buy an ETF tracking an index of healthcare stocks, utility stocks, energy stocks, stocks matching ESG criteria, and many others.
A mutual fund seldom follows a specific index. It may limit its choices to large-cap stocks or emerging market stocks, but won’t be meticulous about exactly holding what is in any index within those categories. Mutual funds tend to reflect the investment styles of their managers, so you can choose a fund that fits the style you want.
Which is the best choice?
It depends on your particular interests and investment preferences. If you want to track an index, a low-cost ETF is an excellent choice. Remember that there are lots of indices, and there are many ETFs out there that track less known indices. It’s not just about the S&P 500!
If you’re looking for a more tailored blend of stocks designed to suit a specific investing philosophy, you’re more likely to find that in a mutual fund. Be prepared to pay a bit more!
Note that some mutual funds also track indices. If you like indexes, your choice of a mutual fund vs. an ETF will depend on your investing style and cost tolerance.
Your Investing Style
There is no such thing as a “wrong” investing style. It is a personal choice. If you are the type that likes to buy and hold, you don’t want to be hopping in and out of an investment. In that case, a mutual fund may work just fine for you.
If you like to follow the news and trade based on the ups and downs of the market, an ETF will work better because you can get in and out quickly.
Many trading platforms offer commission-free trades. However, some brokers will charge you to make the transaction, so do your homework before you press “buy.”
In addition, some mutual funds charge you a fee to buy them. This is called a “load.” You can avoid this fee by looking for “no-load” funds. An ETF will never charge a “load.”
You may do better on your taxes with ETFs vs. Mutual Funds. This is because of some technical ways an ETF is managed vs. how a mutual fund is managed. The short of it is that mutual funds have to sell assets to make up for people redeeming their shares, and this becomes what the IRS calls a “taxable event.” ETFs seldom trigger capital gains taxes within the fund itself.
If you have held shares in a mutual fund or an ETF for over a year, you will pay capital gains tax on any profit from the sale. If you’ve held the shares for less than a year, you will pay your regular income tax rate on your gains. This rate is typically higher than the capital gains tax.
Similarly, you pay lower taxes on dividends when you have held an asset for more than 60 days.
Warning: Taxes are not an afterthought. Consult with a CPA or tax attorney to manage your particular tax situation before you invest or liquidate an investment.
Use Both ETFs and Mutual Funds
You can hold both ETFs and mutual funds in your portfolio. You might consider putting your “don’t touch” money in mutual funds, and then try your market-timing skills in ETFs.
In other words, you can split your investment account money between long-term mutual funds that are the core of your portfolio, and be a little more speculative with a portion that you put into ETFs. That way, you won’t mix the two amounts of money by dipping into mutual funds to buy ETF shares.
Article by Kevin Johnston, FinMasters