Investments

What Is The Difference Between ETF And Mutual Funds

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 8 minute read

It’s possible to invest in anything from stocks to real estate to art. Many investors choose investment-grade funds, which offer diversified market exposure rather than single stocks, bonds, or other assets.

If you decide on this route, choosing between exchange-traded funds (ETFs) and mutual funds will be your most important decision. Which one of these choices is preferable? That, of course, is conditional on your investing objectives. Just so you know, here’s how it breaks down!

ETFs vs. Mutual Funds: What Are the Differences?

There are several similarities between ETFs and mutual funds. Mutual funds and exchange-traded funds (ETFs) are both types of bucket investments that use the combined capital of many people to buy stocks, bonds, and even unusual assets.

Investors in a mutual fund benefit from a rise in the fund’s worth proportional to the value of their individual shares in the fund’s net asset value (NAV). But that’s where the parallels end. There is a large discrepancy between ETFs and mutual funds in terms of costs, tax advantages, asset management, diversification, asset allocation, entry requirements, and liquidity.

Cost

Fees are a fact of investing life regardless of strategy. Management costs for these funds are disclosed to investors in the form of expense ratios, which indicate the annualized proportion of your investment you may expect to spend in management fees. Expect the following expenditure percentages for each available choice:

Fees

The ETF is the more cost-effective choice. The average expense ratio for an exchange-traded fund (ETF) is 0.44% as of this writing, according to the Wall Street Journal. 

Investing $10,000 at that rate would cost you $44 annually in fees for the typical ETF.
Still, before purchasing anything, it’s wise to conduct some homework. Fees can be as little as 0.05% with providers like Vanguard and Fidelity, while some are notorious for charging substantially more.

In terms of trading costs, ETFs are unrivaled. Buying and selling shares of an ETF is typically just as expensive as trading a stock listed on a local exchange. Fees associated with buying and selling these funds have been greatly reduced because of the proliferation of zero-commission brokers.

Mutual Fund Fees

However, most cheap brokers will charge a commission even if you invest in a mutual fund. If you purchase or sell shares in a mutual fund through a broker, you may expect to pay a commission of about $30.

When it comes to pricing for shareholders of mutual funds, the same system applies: the expense ratio. These funds, however, typically come with a significantly heftier price tag. Mutual fund charge ratios decreased from 1.08% in 1996 to 0.71% in 2020, according to a study by the Investing Company Institute.

Although the price of these funds has dropped dramatically over the past few decades, they are still far more expensive than ETFs. It’s more common for exchange-traded funds to have passive management than it is for mutual funds to have active management. When everything is said and done, the extra effort required to oversee the fund’s assets is what’s driving up the price.

Tax Efficiency

The Internal Revenue Service (IRS) is interested in your financial situation if you are generating income in the United States. That’s the case whenever you punch a time clock, launch a new venture, sell a vehicle, or make a financial commitment.

The Internal Revenue Service takes a time-varying approach to investments. Stock market profits are taxable at the investor’s choice of either the lower capital gains rate or the higher ordinary income rate. The capital gains tax rate is lower for investments kept for more than a year compared to the regular income tax rate for investments held for less than a year.
Income tax treatment is a major distinction between the two investment vehicles.

ETF Tax Efficiency

Exchange-traded funds (ETFs) are not only the cheaper alternative, but also the most tax-efficient sort of investment.

Because they are passively managed, ETF assets are rarely actively traded. Only when a fundamental benchmark undergoes a price change will a trade be executed. Since most ETF holdings are expected to be kept for more than a year, the capital gains tax rate at the time of sale will be lower.

Mutual Fund Tax Efficiency

The majority of mutual funds are actively managed, which implies that trades are made often. Multiple trades may occur inside a mutual fund on a single trading day, depending on the fund’s investment objectives and investment strategy as detailed in the fund’s prospectus.

Because of this, most mutual fund investments are deemed short-term, meaning they are held for less than a year. Your ordinary income tax rate applies to any gains from the sale of these funds within a year. Those in higher tax brackets may benefit more from ETFs due to the size of the possible difference.

Asset Administration

When we say that two types of funds are passively managed and actively managed, what do we mean by such terms?

Asset Management for ETFs

Most of these money pools are unattended. Many ETFs, and particularly index funds, aim to replicate the performance of a certain market index. This implies that their portfolio is composed entirely of the assets found in the index, with the hope of achieving the same level of performance.

If the goal of an S&P 500 index fund is to provide investors with returns equivalent to those of the S&P 500 index, then the fund will invest in each stock that makes up the index. The only time the fund will make a transaction is when the S&P 500 makes a modification to the stocks that make up its index; in such cases, companies that are removed from the index will be sold and stocks that are added will be bought to replace them.

Mutual Fund Asset Management

Common stocks and bonds are not handled in the same way as mutual funds. The vast majority are what’s known as “actively managed,” which means that the fund’s management is always on the lookout for methods to boost the fund’s worth. That’s why most people pay out their investments within the first year, and some even inside the first trading day.

Growth, income, value, and factoring are some of the methods these funds employ in order to maximize returns, rather than just replicating an underlying index. These investments try to outperform the market average and the performance of similar exchange-traded funds.
Asset Allocation and Diversification 4

Asset Allocation and Diversification

Typically, funds with a high credit rating engage in a wide variety of assets in order to provide solid returns for their investors. Others will provide a broader variety of asset classes with a slant toward commodities or real estate, while still others will provide a diverse list of stocks, bonds, or a combination of the two. But there is a little distinction to bear in mind:

Diversification of ETFs and Asset Allocation

The diversification of an ETF is dependent on the diversity of its underlying index. A fund tracking the S&P 500 would own a variety of the stocks that make up the index, while a fund tracking the Nasdaq Composite would have more than 3,300 different firms.

Similarly, there is a plethora of themed ETFs that aim to replicate the performance of a certain market segment or class of assets. You may discover an exchange-traded fund (ETF) focused on, say, small-cap technology businesses if you’re interested in making investments in this sector. Remember that funds that follow themes rather than the overall market tend to be less diversified than index funds.

Diversification of Mutual Funds and Asset Allocation

While most mutual funds diversify their holdings, they may not do so to the same extent as exchange-traded funds. Actively managed funds need a dedicated staff to monitor their investments and ensure they are consistent with the fund’s stated goals.

Monitoring and trading 3,000 or even 500 stocks actively would be a hard task without the use of an algorithmic management system. Therefore, while these portfolios are diversified, they are often less diverse than their exchange-traded equivalents.

Initially Invested

Especially for first-time investors, a fund’s minimum contribution amount is a crucial factor to consider. Listed below are the key distinctions between the two choices:

Initial ETF Investment

To begin investing in an ETF, you need only the current market price of a single share. For illustration’s sake, the share price of the Vanguard Small-Cap Index Fund Exchange-Traded Fund (VB) is now about $108.

To participate, you need to put out at least $108 to purchase a share. Because there are so many alternative ETFs to select from, including several with significantly lower share prices, new investors don’t need a large initial investment to get started.

Initial Mutual Fund Investment

The entry barrier for mutual funds is higher for new investors. There are a few low-priced solutions with a $500 minimum commitment, but most require several thousand. At Vanguard, for instance, the minimum investment in actively managed mutual funds ranges from $1,000 to $100,000, depending on the level of active management and the nature of the shares held by the fund.

Liquidity

No matter what kind of investment you’re doing, you should constantly think about your liquidity options. If you need the money from your investment quickly, you shouldn’t be surprised to learn that it will take many weeks, if not months, to get it. Here’s a comparison of the two different kinds of money:

ETF Liquidity

When the time comes to liquidate your ETF holdings, you should have little trouble finding buyers for your shares. An ETF’s liquidity, however, is determined by supply and demand in the market, with widely held funds being more liquid than those with a smaller fan base and lower trading volume.

The size and average trading volume of the fund should be taken into account before making any investments in these sorts of funds. In order to prevent liquidity problems, new investors should stick to investing in funds that have a net asset value of $1 billion or more and are known for strong trading volumes.

Liquidity of Mutual Funds

Exchange-traded funds have a high level of liquidity. This is due to the fact that the majority of these funds maintain a cash reserve of between 3% and 5% of their total assets, which they use to repurchase shareholders’ shares when those shareholders decide to sell.

Due to the fact that these funds are not listed on major stock exchanges, buy and sell orders are often only performed once per day.

Bottom Line

At first glance, exchange-traded funds (ETFs) and mutual funds (MFs) may appear to be identical investments; nevertheless, there are significant differences between the two. One is the exchange-traded fund (ETF), which is intended to mimic the performance of a market segment or the market as a whole. The mutual fund, on the other hand, was created to help people outperform the market.

Keep in mind that not every investment is the same, regardless of your final decision. The fund’s management decides how its assets will be invested, the fees associated with investing in the fund, and the actions the fund will take over time, just as it does with any other product. Do your homework to find out what you may reasonably anticipate from your investment before parting with any cash.

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