Whether you’re looking to get your feet wet or are a seasoned investor, you may be familiar with ETFs and mutual funds. And though the two terms are often used interchangeably and thought to be the same, they have a few distinct differences.
While they both have low barriers to entry and are ideal tools that allow compounding interest to work in your favor, ETFs afford you more control than mutual funds. Read on to learn more.
ETF vs Mutual Funds: How They Differ
There are a few key differences you should be mindful of when comparing ETFs and mutual funds:
- Mutual funds are actively managed, and hedge fund managers make adjustments to the asset allocation strategy whenever the need arises. On the contrary, ETFs trade like shares of stock but it’s up to the investor to initiate trades.
- Mutual funds may be accompanied by more administrative fees than ETFs since additional oversight is needed.
- Mutual funds do not rack up additional fees for the investor each time a trade is made.
- Mutual funds can only be purchased and sold once daily when the trading period comes to an end while ETFs can be traded throughout the day.
A Closer Look at ETFs
Exchange-traded funds are passively managed, index-tracking assets with a primary objective in mind: to match the performance of an index and generate returns for shareholders. This means hedge fund managers can take a step back and let the funds do their job without having to do a ton of intervention, hence passive management.
There are actively-managed ETFs out there, but they are few and far in between and accompanied by slightly higher fees.
Key Benefits
Low Minimum Investment
Both accredited and non-accredited investors are welcome to invest in ETFs, and you don’t have to have deep pockets to do so. In fact, you may be allowed to purchase a single share to get started, and it won’t cost you a fortune.
Investor Control
Because you’re able to trade ETFs shares throughout the day, you’ll be the one calling the shots when the need arises to beef up your holdings of particular assets or sell them off. This level of control is not available to mutual fund holders since hedge fund managers make these decisions on their behalf based on what they feel is best.
Transparency
You’ll know all the pertinent details regarding ETFs you’re invested in each day when their holdings are released to the public.
Key Drawbacks
Commissions
Because ETFs are traded like shares of stock, you’ll be on the hook for fees each time you initiate a trade. This is referred to as a commission. (Quick note: you may be able to find commission-free ETFs through select investment firms, but other conditions may apply).
A Closer Look at Mutual Funds
Mutual funds make it easy to diversify your portfolio without having to do a ton of legwork. They’re comprised of various securities, including stocks, bonds, and other assets, and are available through a host of investment firms, including Fidelity and Morgan Stanley.
You don’t have to be an accredited investor to get started with mutual funds. But the investment firm will require that you open an account with them before you can request and order to invest in mutual funds.
In most instances, annual operating fees will range between 1 and 3 percent of the value of the fund. Fees will also apply when you buy (front-end) or sell (back-end), so it’s important to inquire with the investment firm before moving forward with transactions to ensure the rates are fair.
And instead of receiving dividends that are tied to the performance of the company, you’ll receive annual distributions that are based on the overall performance of the fund.
Key Benefits
Flexible Investment Options
With so many mutual fund options to choose from, you may want to let the professionals handle your initial investment and the management of your portfolio for you. This is referred to as an actively managed mutual fund, and you’ll be assessed additional fees for this luxury.
But if you’re comfortable with the idea of handling your own portfolio, consider a passively managed fund with lower fees. They aim to mimic the performance of a market index, such as Nasdaq, so you won’t have to be as involved in the management of your portfolio.
Diversification
The most significant benefit that mutual funds afford investors is the ability to diversify their portfolio and minimize risk without racking up a ton of fees buying or selling securities. How so? As mentioned earlier, mutual funds are a melting pot of assets. And even if one or two of the company’s in your fund experience a bit of turbulence or there’s an industry-wide shakeup, you may not take a major hit since there are other assets in the fund that can possibly absorb some of the losses.
Favorable Tax Treatment
Earnings garnered from the sale of mutual funds at a premium result in capital gains taxes. The good news is that capital gains are taxed at a lower rate than ordinary income.
Key Drawbacks
Lack of Transparency (compared to ETFs)
if you invest in a mutual fund, you’ll only get an estimate of what it’s worth, or the Net Asset Value (estimated value of assets – the aggregate number of liabilities) at the end of each day when trading comes to a halt.
Which Option Is Best?
When you’re just getting started or don’t have a ton to invest, purchasing a few ETF shares may be more ideal as the minimum investment is lower and you won’t incur a ton of fees. But if you’re looking to beef up your nest egg or accumulate substantial earnings in a short time frame, mutual funds may be more suitable.
Ultimately, it’s up to you to iron out your investment goals. And by soliciting the input and assistance of a financial adviser, you’ll be given sound advice to help reach your investment goals in record time.
