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Mutual funds and ETFs make excellent investments. They both simplify diversification by combining different stocks or bonds into a single “basket.”
However, there are some important differences you should consider before choosing. After reading this article, you will be able to clearly decide if ETFs or Mutual Funds will best suit your investment needs.
What is a Mutual Fund?
A mutual fund is usually professionally managed by a fund manager. The fund manager actively picks investments to include in his or her mutual fund, in attempt to outperform the returns of the total stock market. Such investments may include stocks, bonds, foreign currency, and other securities.
You can go to the “portfolio” or “composition” page of any mutual fund description and see what the mutual fund is made up of. Please see the images below for an example from Fidelity and Schwab.
Due to mutual funds being actively managed, they usually come with a higher expense ratio, even up to 1%.
It should be in your best interest to avoid mutual funds with high expense ratios because they eat into your portfolio performance. For example, Vanguard has a chart that gives you a clear visual of what high expense ratios can do. You can lose more than half of your portfolio returns with a 2% expense ratio. Please see the image below.
Unlike a stock, you cannot trade mutual funds throughout stock market hours. Instead, trading occurs once a day at 4pm, when the stock market closes. You also cannot sell short or trade on margin, or use orders such as stops and stop limits.
Mutual funds are usually bought and sold in dollar amounts instead of shares. This means when you place an order, you enter the amount of dollars you would like to invest, instead of the number of shares.
Oftentimes you will find mutual funds with a minimum initial investment requirement. For example, Vanguard’s VFIAX has as minimum initial investment requirement of $3,000, which can be a steep price for many people. However, there are many companies that offer mutual funds with zero minimum initial investment requirements like Schwab and Fidelity.
Another type of mutual funds – Index Funds
Index funds are actually a sub-category of mutual funds. They are a type of mutual fund, just managed a bit differently.
Index funds are passively managed and do not require active engagement by the fund manager like other mutual funds. Because they simply track a benchmark, this also significantly brings down the expense ratio, making it a better investment.
What is an ETF?
ETF stands for “exchange-traded fund.” Just like mutual funds, they are a basket of stocks or other securities combined into a single “stock.”
Unlike mutual funds, you can trade ETFs throughout the day. This means you can buy and sell throughout stock market hours like any regular stock. You also may sell short and trade with margin.
The majority of ETFs are passively managed, which in turn lowers the expense ratio. Expense ratios are lower because the ETF does not rely on the fund manager’s expertise to actively pick stocks.
Because ETFs trade like regular stocks, you purchase ETF shares. There is no minimum initial investment requirement, but you may need enough money to purchase the price of one share. However, many brokers these days offer fractional shares, which means you can purchase a share for a fraction of the actual price.
What does InvestaMind recommend?
We recommend investing in index funds for tax-advantaged accounts, and ETFs for regular brokerage tax accounts. ETFs are slightly more tax-efficient, so holding them in a taxed account will bring some benefit. Let me explain.
ETFs do not distribute capital gains whereas mutual funds do. Capital gains are taxable.
When you sell shares of a mutual fund, the fund manager has to rebalance the fund by selling securities to accommodate your sell order. This triggers capital gains for other people who are invested in the fund. If you do choose to invest in mutual funds in a taxable account, it is a good idea to make sure the turnover rate is low – less than 4-5%.
Most brokers do not allow automatic investment into ETFs. Therefore, by investing in mutual funds in a tax-advantaged account, you can take advantage of automatic investments, and by investing in ETFs in a taxable, you can take advantage of the tax-efficiency.
Conclusion
The important takeaway for today is that ETFs are a bit more tax-efficient than mutual funds, but more brokers offer automatic investment functions only for mutual funds. Also, if you choose a mutual fund, make sure you keep an eye out for the expense ratio – this is the money that will have to come out of your pocket, and if too high, will eat away at your investments.
I hope you enjoyed today’s lesson. Please leave a comment below for any content suggestions or general questions!