Table of Contents
Introduction
Investing is an exciting process, and there are many ways through which one can start building their wealth. Two of the most common that are usually suggested are exchange traded funds (ETFs) and mutual funds. Both of these options allow investors to expand their investment portfolio and taste a bit of everything in the investment world. Nevertheless, there are some distinctions between ETFs and mutual funds that you should be aware of before making your choice. In this article, we are going to explain what makes ETFs different from mutual funds and how to choose the right investment vehicle for your situation.
What are ETFs?
Exchange traded funds, or ETFs, are typed of investments that trade on exchanges like a normal stock. They are set up to mimic a particular index, sector, commodity or asset class and are traded like a share and can be bought and sold during the course of the day at the market price which gives the investor a lot of flexibility and liquidity.
One of the main advantages of ETFs is that they have lower expense ratios than mutual funds. This is because ETFs are relatively passive funds that seek to replicate a specific index, which means they generally incur lower management fees than actively managed mutual funds. This may lead to better returns for investors in the long run.
Another advantage of the ETFs is their tax efficiency. This is because of their structure, they usually generate lower capital gains distributions than mutual funds. This can be especially useful for the accounts that are taxable as it helps to keep down the amount of tax that is paid on the returns.
What are Mutual Funds?
On the other side, mutual funds are investments vehicles that pool together money from several investors and then invest in a portfolio of securities which may include stocks, bonds or both. Unlike ETFs, mutual funds are traded only once at the end of the day based on the NAV of the assets held in the fund.
There are two types of mutual funds: active and passive. Actively managed mutual funds have their manager picks stocks and makes investments decisions based on research and experience. On the other hand, passively managed mutual funds, also known as index funds, seek to emulate a particular index’s performance with lower expenses than actively managed mutual funds.
The main advantage of mutual funds is that they are easy to understand. Investors can redeem or purchase shares directly from the fund company or through a brokerage account without any restriction. Furthermore, mutual funds provide many choices of investments, which help the investors to select funds according to their investment objectives and risk appetite.
The differences between ETFs and Mutual Funds.
Now that we have a better picture of what an ETF and a mutual fund are, it’s about time to look at the differences between the two:
Trading Flexibility:
ETFs trade on stock exchanges during the day and investors can purchase or sell the shares at the market price. This gives you more flexibility and the ability to act quickly in response to market events. At the end of the trading day, mutual funds are priced – you only have the ability to buy or sell shares at the NAV price.
Expense Ratios:
As already mentioned, ETFs have lower expense ratios than mutual funds. This is especially the case with ETFs since they are passively managed while mutual funds may incur higher management fees due to active management.
Tax Efficiency:
ETFs are usually considered as tax efficient because they tend to have lower capital gains distributions which is useful to the investor especially in a taxable account. On the other hand, mutual funds are known to have higher distributions which may lead to high tax liabilities.
Minimum Investment Requirements:
Many mutual funds have minimum investment requirements, which can be different across the funds. Some may require you to invest at least $1,000, while others may have none at all for certain accounts. As for ETFs, you can usually buy them as easily as the price of one share plus brokerage fees.
Transparency:
Here, we can say that ETFs are more transparent than mutual funds. This is because ETFs are exchanged in the market and their holdings are revealed on daily basis. On the other hand, mutual funds tend to reveal their holdings on a quarterly basis, which means that you may not know what is invested in your account at any point of time.
Which Investment Vehicle is Right for You?
Having outlined the differences between ETFs and mutual funds, you may be thinking how to choose what fits you best. Here are some considerations:
Investment Goals:
First of all, think about what you want to achieve and how much time you are willing to invest. If you are planning to hold for the long run and want to invest in the entire market with minimal fees, then ETFs may be the right choice for you. If you prefer active management and are willing to pay more for the chance to outperform the market, then mutual funds may be more suitable for you.
Trading Flexibility:
If the ability to trade at any time during the day is important to you, then ETFs are probably more attractive. For buy and hold investors, the end of day pricing of mutual funds may not be a big issue.
Tax Considerations:
For the individual trading in a taxable account, consider how much you require your investments to be tax effective. ETFs normally come with lower capital gains distributions than other forms of investments which in turn reduces the amount of tax to be paid. However, if your investments are made in tax advantaged accounts like IRAs or 401(k)s, then the tax benefits of ETFs may not be so relevant.
Investment Amount:
Take a moment to determine how much you are investing. If you are beginning with a smaller amount, then ETFs could be more appropriate as they are bought by share price only. On the other hand, mutual funds can have issues such as minimum investment requirements.
