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ETF vs. mutual fund: Which is right for you?
They both hold baskets of investments but pricing minimums and trading costs vary.
But there are key differences that separate these types of funds, and one may be a better fit for your portfolio than the other. It all boils down to how much you have to invest and how you prefer to manage your funds.
ETF vs. mutual fund: Which should I choose?
ETFs are likely the right choice if:
- You don’t have a lot to invest.
- You want low-cost access to a market.
- You prefer fully transparent pricing.
- You want to move in and out of your investments quickly.
- You want short or leveraged access to specific asset classes.
Mutual funds are likely the right choice if:
- You want a professional to oversee your investment.
- You want a chance to do better than an index.
- You don’t want to be concentrated in certain sectors.
- You want access to specific asset classes such as property or private equity, which are difficult to achieve with ETFs.
What are ETFs?
An exchange-traded fund (ETF) is a collection of assets bundled and sold as a single investment. The most popular ETFs track major indexes such as the S&P 500 or FTSE 100. Buying a share gives you a piece of every stock in that index. These days you can find ETFs that track nearly every form of investment. They’re a relatively low-cost and liquid way to invest in almost any asset or strategy.
While the mutual fund market is larger, the ETF market has grown significantly in recent years. The US ETF market surpassed $5 trillion in value in 2020.
There are ETFs based on currencies, commodities, volatility indices and sectors. There are inverse ETFs that allow an investor to benefit from falling prices and leveraged ETFs that give investors greater exposure to an individual asset or index — and with that, greater exposure to risk.
ETFs trade on exchanges, like stocks, with prices that fluctuate throughout the day.
What are mutual funds?
Like ETFs, mutual funds also invest in a basket of assets that can be bought and sold as a single investment. Mutual funds are actively managed by a fund manager, who — you guessed it — manages the fund by buying and selling assets. Managers have benchmarks and targets to meet or exceed, and state their strategies for investors to study. Knowing the benchmarks and the fund manager’s performance record is key when picking a mutual fund.
Mutual funds do not trade on an exchange — the shares are priced once daily, based on their current net asset value.
ETFs vs. mutual funds: An overview
Exchange-traded funds and mutual funds are equally worthy of consideration for any investor — they hold similar selections of investments and can help diversify your portfolio. But there are some general differences to take into account before you buy.
|Exchange-traded funds||Mutual funds|
|Selection of assets||Stocks, bonds, currencies and commodities||Stocks, bonds, currencies and commodities|
|Minimum investment||Typically $50||Typically $1,000|
|Expense ratios||0.2%||0.5% to 0.75%|
|Trading commissions||$0||$19.99 to $49.99 per fund|
|Taxes||More tax-efficient||Less tax-efficient|
Selection of assets
What makes exchange-traded funds and mutual funds so similar is their structure and selection of assets. Both blend baskets of stocks, bonds, currencies and commodities — and in many cases, the mix of investments will be the same. For example, an S&P 500-based mutual fund and an S&P 500 ETF may hold many of the same stocks.
What’s more is that both types of funds can help you diversify your portfolio without breaking the bank. And they both tend to be less risky and much simpler than picking and choosing individual stocks and bonds.
If you’re looking for an investment with a lower minimum, opt for an ETF. That’s because mutual fund minimums typically start at $1,000, while ETF minimums tend to hover around the $50 mark.
Passive vs active management
Actively managed funds are overseen by a real person: the fund manager. While passively managed funds just try to replicate an index or the match performance of an asset. When dealing with an actively managed fund, you’re likely to encounter higher fees. Those fund managers need to get paid, after all.
Mutual funds are actively managed. And for the most part, ETFs are passively managed.
The active versus passive choice has instigated many arguments among investors. Those who prefer passively managed funds argue that most actively managed funds don’t perform better than indexes, so it’s not worth paying the extra fees that cover the managers’ salaries. Those who support active management argue that skilled fund managers can deliver performance well ahead of an index, which justifies their fees.
Whatever your view, reading a fund’s documentation will tell you how it’s run, who manages it and what its track record is.
Here’s another place ETFs have mutual funds beat: expense ratios. An expense ratio is an administrative fee you pay to participate in the fund. Expense ratios vary for both types of funds, but the average ETF expense ratio is about 0.2%, while mutual fund expense ratios tend to be 0.5% to 0.75%.
Why are mutual funds more expensive? Because you’re paying for an actively managed fund that’s overseen by a fund manager. Mutual funds also tend to trade more often.
Most ETFs are available commission-free — which is to say, you won’t pay a trading fee when you buy or sell ETFs. But mutual funds? Expect to pay $19.99 to $49.99 per fund transaction.
Both ETFs and mutual funds are subject to capital gains tax. But ETFs tend to minimize taxes for investors because there are fewer taxable events. When money flows in and out of mutual funds, the fund manager must rebalance the fund by moving investments around — which can generate capital gains for shareholders.
ETF managers, on the other hand, create baskets of assets called “creation units” to minimize capital gains. The exchange of ETF creation units is considered to be in-kind instead of an outright sale, and this helps insulate investors from capital gains.
ETFs vs. mutual funds: Summary
Both mutual funds and ETFs are worthy of consideration. In fact, many investors choose to hold both in their portfolios.
Depending on the market, one type of fund may outperform another. But the right choice ultimately comes down to your investment strategy.
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