When you start work, the key to fast-tracking yourself to investor status is through building yourself a cash pile and reducing debt.
As your savings grow, you’ll want to start to put them to work for you. What do we mean by that? It’s not like your money physically picks up a shovel and gets ready for a day of hard labor.
Allowing your money to work for you instead of working for your money means that you collect income from placing your money in income-generating assets. As a result, your money grows without you needing to manage any accounts.
When investors start their journey to financial freedom, two of the most common beginner-level investments are ETFs and mutual funds. These vehicles allow investors to park their money with a management firm, who then invests the capital into the markets for them.
In some cases, it’s possible to manage your investments yourself, but many rely on the use of a fund manager’s expertise at picking the best-performing assets. In return for leaving your money with the management firm, they pay you a return. They base this return on the performance of the fund in relation to the market.
Exchange-traded funds (ETFs) and mutual funds have quite a lot in common when it comes to the utility they offer to investors and the characteristics of the asset. There are a few key differences between ETFs and mutual funds, with ETFs trading like regular stocks, and mutual funds only allowing purchases at the end of the trading day.
Most mutual funds operate under an actively managed strategy. The fund manager actively trades the account according to their trading strategy. ETFs are passively-managed assets that have close ties to market indexes.
According to research from the Investment Company Institute, more than 8,000 mutual funds are operating on the capital markets, with a total of $17.71-trillion in assets under management, in December 2018.
The same study shows that there are almost 2,000-ETFs, with a total of $3.37-trillion in assets during the same period.
Mutual Funds Vs. ETFs – The Showdown
So, what’s the difference between an ETF and a mutual fund? Both of these assets are readily available, so which one should you allocate to your portfolio?
What are Mutual Funds?
Most mutual funds come with a higher minimum investment cost than ETFs. The fund minimums vary dependent on the rules set by the financial services provider that manages the fund. For example, the Growth Fund of America from American Funds offers a minimum funding requirement of $250. However, the Vanguard 500 Index Investor Fund requires a minimum starting deposit of $3,000.
Some mutual funds may comprise of a team of traders and managers directing and implementing the investment strategy of the fund. Strategies differ from fund to fund, and it’s the defining reason for the variations in performance across the industry.
Performance dictates who is the market leader, and who gets the most clients – everyone wants to invest with the fund achieving the best return. As a result, some funds are selective with their minimum deposit requirements.
Read More: What is a Mutual Fund?
What are the Two Types of Mutual Funds?
Mutual funds have two legal classifications describing how the funds operate.
What are Open-Ended Mutual Funds?
These types of mutual funds are the most popular type, dominating the marketplace in assets under management and volume. Open-ended funds cater to the sale and purchase of fund shares directly between the company and investors.
With open-ended funds, there are jo limitations on how many shares the company can issue. Therefore, as investors buy into the fund, it creates more shares under the direction of management.
All mutual funds must adhere to federal regulations that require the daily valuation of all shares, called the “marking to market” process.
Marking to market adjusts the mutual funds share price to reflect any changes in the asset value of the portfolio. It’s also important to note that the total number of shares outstanding has no impact on the individual share value.
What are Closed-End Mutual Funds?
These mutual funds only issue a fixed number of shares, and the fund does not issue new shares as investor demand rises. The investor demand for shares drives the share price and not the net asset value (NAV) of the mutual fund.
Share purchases occur at price points that are typically at a discount or premium to the portfolio NAV.
Before deciding on either portfolio, it’s also essential to consider the fee structure and tax implication of these mutual fund investments.
What Is an Exchange-Traded Fund? (ETF)
Exchange-traded funds trade in the same manner as for regular stock. As a result, they can cost far less than the cheapest mutual funds minimum investment amount to get in on the action. The price of one share, plus fees and commissions, gets you into the ETF.
Recently, fractional brokers and no-commission brokers are changing the way ETFs make money. As a result, it’s giving a broader demographic of new investors the chance to invest in ETFs. Earlier in 2019, apps like Robinhood allowed investors to invest in ETFs with no commissions, directly from their mobile device.
It wasn’t long before all the leading firms like Charles Schwab, eTrade, Interactive Brokers, and TD Ameritrade followed suit, launching offerings of commission-free mobile trading platforms to the public.
Institutional investors create or redeem large lots on ETFs and then trade the shares between investors during the trading day, much like an ordinary stock. Most ETFs consist of assets like commodities, such as NATGAS, the natural gas producer.
However, like a stock, ETFs can also sell short, creating an additional market for investors. Investors can’t short mutual funds, and that makes a significant difference in the performance and volatility of the funds share price.
In short, mutual funds cater more for the long-term investor, whereas an ETF can provide a market for a variety of day trading, swing trading, and long-term investment strategies.
ETFs also create opportunities for arbitrage traders as well. Due to the continuous pricing, there’s potential for the ETF share price to trade above NAV. As a result, this situation presents an entry for an arbitrage trade.
Read More: What is an ETF?
What’s the Difference in Buying ETFs and Mutual Funds?
Similar to stocks, ETFs have a listing on the major stock exchanges like the NASDAQ and NYSE. Therefore, to buy and sell ETFs, you need to open a brokerage account. As mentioned, numerous discount brokers are offering low-cost trading accounts with low account minimums and no commissions.
With Mutual funds, the fund manager trades share directly with the market. As a result, you don’t need a brokerage account. You can contact your fund manager or financial advisor to move your money between mutual funds as per your investment goals.
With an ETF, the market offers you a bid and ask price for buying and selling the ETF. There’s typically a spread between the bid and the ask, depending on the ETF. Most transactions take place between the bid and the ask, which is the market premium you pay.
Let’s assume you want to invest in an ETF with $5,000, at a final share price of $45 per share.
Therefore, you’ll need an order for 111-shares of the ETF (111-shares x $45 share price = $4,995 total cost). Being that ETFs trade throughout the regular trading day like regular stocks, they offer investors higher levels of flexibility and transparency over mutual funds.
In contrast, mutual funds only receive pricing after the market closes, when the funds tally up the NAV. Therefore, for our example, if you want to invest your $5,000 into a mutual fund priced at $45 per share, you’d contact your broker, and they would buy into the fund for you, and you receive your shares at the end of the trading day.
Expense Ratios and Taxes with ETFs
There are some passively-managed mutual funds, but most of them have managers running an active trading strategy with the funds capital. ETFs, on the other hand, require your direct involvement with the purchase and sale of shares, and you have to decide on your investment strategy when trading your brokerage account.
Therefore, ETFs typically have far lower costs involved with trading when compared to actively managed mutual funds. With an ETF, you can avoid commissions and management fees involved with mutual funds,
According to research by the Investment Company Institute (ICI), average expense ratios for index ETFs come in at 0.21%, while average expense ratios for mutual funds is 0.78%.
ETFs also lower your tax bill because they have fewer trades throughout the year, and a lower turnover, which helps to minimize the capital gains tax distributions.
It’s also important to note that ETFs don’t need to sell to meet investor’s redemption requests. That’s not the case for mutual funds, where redemptions might generate taxable capital gains.
ETF Vs. Mutual Fund – Investor Tax Example
As an example, should an investor in a mutual fund decide to redeem $50,000 from a Standard & Poor’s 500 Index fund (S&P 500), the fund must liquidate (sell) $50,000-worth of stock on the open market.
If the investor frees up cash by selling appreciated stock, then the fund captures the capital gain, distributing it to its shareholders by the end of the year. As a result of the transaction, the shareholders will pay taxes for the funds turnover.
If an ETF shareholder chooses to redeem shares worth $50,000, the ETF doesn’t have to sell any of the stock in its portfolio. Instead, the ETF offers its shareholders “in-kind redemptions,” that limit the possibility of capital gains tax.
What are the Three Types of ETFs?
As an ETF investor, you should know that there are three different types of ETFs available for your consideration.
Exchange-Traded Open-End Index Mutual Funds
This type of ETF has registration with the SEC Investment Company Act of 1940, where the ETF reinvests any dividends on the day of receipt, paying the shareholders cash each quarter. The rules governing the fund allow for the lending of securities, and the use of derivatives.
Exchange-Traded Unit Investment Trust (UIT)
The Investment Company Act of 1940 also governs exchange-traded UITs, but they must make the best attempt to replicate specific indexes in their entirety.
Other rules include the need to limit any investments in a single stock issuance to 25% or less, setting additional weighting-limits for non-diversified and diversified funds.
UITs don’t automatically reinvest investors’ dividends. Instead, they pay investors out with cash dividends every quarter. Some great examples of UITs include the Dow DIAMONDS (DIA), and the QQQQ.
Exchange-Traded Grantor Trust
This kind of ETF has an uncanny resemblance to a closed-end fund, but the investor owns underlying shares in companies in the ETF. Investors also get voting rights like traditional shareholders as well.
The fund’s composition does not change, and there’s no reinvestment of dividends, only direct payments to shareholders. Investors must also take trades in lots of 100-shares, with Holding company depository receipts (HOLDRs) being an excellent example of this ETF.
ETF Vs. Mutual fund – Key Takeaways
By now, you should have a good understanding of the difference between ETFs and mutual funds.
When it comes to selecting the right one for you, your decision should reflect your investment strategy and retirement goals.
When looking at both investments from a long-term perspective, we find that mutual funds offer superior returns on average, but they also have a higher expensed ratio. Management fees matter when it comes to long-term profits, and every percentage point you give up to managers will hurt your returns in the long term.
Therefore, an ETF might make lower returns, but it makes up for it with tax breaks, lower fees, and total control over your investments. Still, there’s a reason why you pay a professional to do the job when investing in a mutual fund.
When investing in the long-term, you need to have the advice of professionals that know the market and the best-performing stocks and ETFs. Investing with a mutual fund allows you to leverage this knowledge, reducing the risk in the deal.
However, the final choice is up to you, trade accordingly.