Mutual funds with nearly a century of history and their more modern counterpart, Exchange-Traded Funds (ETFs), are both investment tools composed of a diverse range of securities. You can purchase shares of these instruments through brokers or other providers and thus simultaneously have financial stakes in many companies. Depending on the differences in structure, trading, and taxation of each of these financial instruments and based on your investment style, you can choose one of them. Here on FFMAG, we intend to delve into the differences between mutual funds and ETFs.
What are Mutual Funds?
Mutual funds are investment tools that gather money from many investors and use it to purchase a large basket of stocks for diversification purposes. These funds are managed by professional managers who aim to increase the fund’s value through buying and selling assets based on the fund’s objectives.
The total value of a mutual fund depends on the total value of the securities it invests in, as well as the performance of those securities in the market. The value of a mutual fund share, also known as Net Asset Value (NAV), is calculated by dividing the total value of the fund’s assets minus its liabilities by the total number of shares outstanding.
How Mutual Funds Work
When you invest in a mutual fund, you receive shares of the fund (and not actual shares) based on the amount invested (I) divided by the current NAV (Net Asset Value) of one share. In other words, the number of shares equals I/NAV. For example, if you invest $1000 in a mutual fund with a current NAV of $30, you will receive 33.33 shares because:
$1000 / $30 = 33.33
If the NAV increases by $1 by the end of the next trading day, you have gained a profit of $33.33, and your initial investment of $1000 is now worth $1033.33:
33.33 shares x $1 = $33.33 + $1000 = $1033.33
This process can continue with the increase or decrease in the value of your investment depending on the performance of the fund’s shares. If you decide to sell some (or all) of your shares, this will be done at the end of the market day based on the NAV at that time. You can earn income from mutual funds through capital gains, dividend distributions, and NAV increases. The table below provides a quick overview of the differences between mutual funds and ETFs.
Advantages and Disadvantages of Mutual Funds
Although in many portfolios, ETFs have replaced mutual funds, mutual funds have advantages that are much more prominent in the minds of certain types of investors. Among the pros and cons of mutual funds, we can mention the following:
Advantages of Mutual Funds:
- Diversification: For those seeking diversity but lack the time, interest, or budget to pick stocks themselves, mutual funds offer an easy option to achieve such a goal.
- Professional Management: Mutual funds with active management provide opportunities for better returns through specialized and active management.
- Convenience: Mutual funds allow you to automatically reinvest share earnings and capital distributions.
Disadvantages of Mutual Funds include:
- Higher Costs: Professional expertise comes at a cost, so actively managed mutual funds typically have higher investment expenses compared to ETFs.
- Higher Capital Gains Taxes: Shareholders must pay taxes on gains earned, even if the fund as a whole has had poor performance.
- Lack of Transparency: Unlike ETFs, which are required to disclose their assets daily, mutual funds do not have this obligation.
- Less Liquidity than ETFs: Mutual fund shares are only redeemable once at the end of each trading day, which makes their liquidity less compared to shares or ETF shares.
What are ETFs?
ETFs are a type of exchange-traded investment instrument that must be registered with the Securities and Exchange Commission (SEC). Essentially, ETFs offer a combined investment in a fund that buys shares and, similar to mutual funds, offers its own shares to investors. Most ETFs are passively managed, meaning that the fund tracks a specific index such as the S&P 500. This eliminates the need for management fees associated with active fund management.
Since ETF shares are traded throughout the trading day on the stock exchange, the value of each share constantly changes and may be equal to or different from the NAV of the fund shares. It is worth noting that the NAV of an ETF is calculated by dividing the value of the ETF’s assets minus its liabilities by the number of shares outstanding.
ETFs, like mutual funds, are considered by investors for various reasons. Portfolio diversification and liquidity, as well as transparency and tax efficiency, are among the differences between mutual funds and ETFs.
How ETFs Work
Investing in ETFs is similar to investing in the stock market because ETF shares are traded on the securities exchange and at market prices. Here too, unlike a mutual fund, you are not buying with a fixed amount; instead, you are purchasing a certain number of shares at the current market price. This is because, unlike mutual funds, ETFs usually do not offer fractional shares.
For example, suppose you have the same $1000 to invest in an ETF, and the market price of the stock you want to buy is $30. Since you usually can’t buy fractional shares in an ETF, you’ll receive 33 shares at a price of $990 ($1000 / $30 = 33.33), with $10 remaining as cash.
If the market price increases by $1, you can sell your shares and make a profit of $33 (though not the full $33.33 amount you received in the ETF example). Remember, you’re buying and selling shares based on market prices, not Net Asset Value (NAV). While market prices and NAV usually don’t differ much, there are variations. When the market price is higher than NAV, shares are said to be selling at a premium. When the market price is lower than NAV, shares are said to be selling at a discount.
Read More: Unlocking Financial Opportunities: Exploring the Power of Purchase Funds
Advantages and Disadvantages of ETFs
Similar to mutual funds, ETFs have their own advantages and disadvantages; although depending on your investment approach, they may have fewer disadvantages compared to mutual funds. Among the advantages and disadvantages of ETFs, the following points can be mentioned:
Advantages of ETFs:
- Diversification: Like mutual funds, ETFs offer an easy and cost-effective way to diversify your portfolio without the need to buy individual stocks.
- Tradability: Since ETFs are traded like stocks, you have the opportunity to take advantage of stock price fluctuations throughout the trading day.
- Transparency: In almost all cases, the assets held in an ETF must be disclosed daily so investors know what they own. This is in contrast to mutual funds, which typically disclose their holdings quarterly with a 30-day delay.
- Liquidity: Since ETFs can be bought or sold on the stock exchange throughout the trading day, ETFs are considered to have good liquidity.
Disadvantages of ETFs:
- No fractional shares: One difference between mutual funds and ETFs is that most ETFs do not offer fractional shares, meaning you have to buy a specific number of shares.
- Passive management: For ETFs that track an index, we may potentially see lower returns.
- Tracking errors: ETFs may have tracking errors in downtrends and may not track such trends well.
Key Differences Between ETFs and Mutual Funds
Mutual funds and Exchange-Traded Funds (ETFs) are two of the most common investment vehicles in the modern world. These investment tools, despite their similarities, are also distinguished from each other in important ways.
Both mutual funds and ETFs are diversified investment tools that offer investors a diversified basket of assets. Both ETFs and mutual funds are tools that can help you save for retirement. Investors have many options to choose from, and they can use them across a wide spectrum of financial markets. Below are the key differences between mutual funds and ETFs.
Management Approach: A key difference between mutual funds and ETFs
Typically, mutual funds are managed by a professional manager who tries to make profits by buying and selling stocks in the market using their expertise in investment. This approach is called active management and usually involves higher costs for investors. Also, active management can mean subpar performance because fund managers usually aren’t very successful in predicting market performance.
On the other hand, ETFs are usually managed passively. These funds automatically track a pre-selected index like the S&P 500 or the Nasdaq 100. However, there are also actively managed ETFs that operate more like mutual funds and therefore have higher fees.
While actively managed funds may perform better than ETFs in the short term, their long-term results tell a different story. Between the higher expense ratio and the possibility of underperforming the market, actively managed mutual funds often have lower returns compared to ETFs in the long run.
Expense Ratio: Another key difference between mutual funds and ETFs
The expense ratio indicates how much investors pay annually to own a fund as a percentage of the amount invested.
It’s worth noting that passively managed ETFs are relatively inexpensive; some have expense ratios as low as 0.03%, meaning investors pay only $0.30 per year for every $1000 invested. This amount is significantly less than the expense for a mutual fund. In 2021, the average expense ratio for actively managed funds was 0.60%, while the average for passively managed funds was 0.12%. However, it shouldn’t be assumed that ETFs are always the cheapest option.
Trading Method: Prominent Differences Between Mutual Funds and ETFs
Typically, ETFs track an index and their prices are determined moment-to-moment based on supply and demand, much like stocks. On the other hand, traditional mutual funds, even index-based ones, are priced and traded at the end of each trading day.
In fact, the stock-like trading structure of ETFs means that when buying or selling, you may incur commissions. However, this landscape is evolving; there are now many large brokerages that no longer charge commissions. While this is good news for ETF buyers, remember that many brokers still expect you to hold an ETF for a certain number of days, or else they’ll charge you a fee. In essence, ETFs are not usually ideal for daily trading.
Taxation: Another Difference Between Mutual Funds and ETFs
ETFs are said to be generally more tax-efficient than mutual funds due to their management style. This becomes significant when an ETF is held in a taxable account rather than a tax-deferred retirement account. When you, as an investor, buy an ETF, you don’t pay taxes on capital gains unless the shares are ultimately sold for a profit.
On the other hand, mutual funds are structured in a way that exposes them to higher capital gains taxes. Because they are actively managed, their assets are bought and sold more frequently. When these transactions result in gains, the capital gains tax is passed on to all shareholders, even if they never sold their shares.
Minimum Investment
The cost of entry into mutual funds can be quite high. Even mutual funds that help novice investors pursue specific savings goals often have minimum investments of $1,000 or more. On the contrary, ETFs can be purchased on a per-share basis, reducing the cost of opening or adding to a position.
Considering the differences between mutual funds and ETFs, make your decision
As an investor, you shouldn’t assume that investing is low-cost. Always examine potential fees. Despite the popularity of ETFs for being low-cost, this holds true for ETFs as well. Generally, ETFs offer investors a broad view of the market and can provide diversification with minimal fees. On the other hand, actively managed mutual funds can be suitable for a different spectrum of investors.
Also Read: Navigating the Markets: Top ETF Trading Strategies for Novice Traders