While mutual funds and exchange-traded funds (ETFs) share many characteristics, they are actually quite different. These assets vary in terms of trading method, expenses, management style, liquidity, minimum investments, and more. The ideal type of fund for your portfolio will vary depending on your investment goals and how close you are to retirement.
Read on to learn more about what makes mutual funds and ETFs different from one another — and which is best for your needs.
Mutual Funds
Mutual funds are investment vehicles that pool money from many investors to purchase a diversified portfolio of stocks, bonds, or other securities. Investors can purchase mutual fund shares directly through brokers like Vanguard and Fidelity.
How Are Mutual Funds Managed?
Most mutual funds are actively managed by professional portfolio managers or a team of managers who select individual securities to include in the portfolio. For equity funds, this mostly involves choosing stocks; for bond funds, it involves selecting bonds.
While actively managed mutual funds have the potential to outperform the general market, they're usually a more expensive choice. In addition to expense ratios (which may be higher than ETFs to accommodate for active staff) some mutual funds also charge load fees. Front-end load fees are paid upfront when you purchase the fund, while back-end funds deduct fees when you exit your position.
What is the Minimum Investment?
The minimum investment for each mutual fund is set by the brokerage or holding company that manages the fund. These minimums vary by fund and are often significantly higher than the cost of one share. For example, most actively managed Vanguard funds have an initial minimum investment of $3,000. However, some certain sector-specific index funds may have minimums as high as $100,000. Review a fund’s individual prospectus to learn more about its minimum investment.
Exchange-Traded Funds
ETFs are pooled investment vehicles that hold a collection of assets (stocks, bonds, or commodities) and trade on stock exchanges like the New York Stock Exchange (NYSE) or NASDAQ throughout the day. When you purchase a share of an ETF, you gain exposure to all of the assets included in the fund, offering instant diversification. You can see what assets the fund owns by reviewing its list of holdings, which you can find on the management company’s website or in your brokerage account. You can also see which assets make up most of the fund’s holdings, broken up by percentages.
ETFs often track a specific index, sector, or asset class. They offer investors liquidity and typically lower costs than mutual funds.
How Are ETFs Managed?
There are two major ways that ETFs are managed: passive or active.
Passive
The majority of ETFs are passively managed, meaning they are designed to mimic the performance of a certain financial index as closely as possible. They accomplish this by designing their asset list to match the details of the index. For example, an S&P 500 index fund would invest in stocks of the top 500 companies in the country using about the same weighting measure as the S&P 500 index.
Because passive ETFs track an index, there is usually little need for management rebalancing. This makes passive ETFs more affordable than active ETFs — you can learn about an ETF’s relative cost by considering its expense ratio.
Active
Some ETFs are actively managed, meaning that portfolio managers make investment decisions with the goal of outperforming a specific benchmark or achieving a particular investment objective. These ETFs may not follow a specific index, and their holdings may change at the fund managers’ discretion.
An example of an actively managed ETF is the Capital Group Dividend Value ETF (NYSE: CGDV). This fund employs a team of managers to identify undervalued, dividend-paying stocks to produce a stable income stream for investors. The top two investments in the fund are stock from RTX (NYSE: RTX) and Microsoft (NASDAQ: MSFT), which comprise about 10% of the fund’s total assets.
What is the Minimum Investment?
The minimum investment in an ETF is the current price of one share of the fund. For example, the iShares Core S&P Small-Cap ETF (NYSE: IJR), a passively managed fund focusing on small-cap domestic stocks, is trading at $113.07 as of August 15, 2024, so $113.07 is the minimum investment amount for this fund. This means that the price you’ll pay to buy into the fund can change on a minute-to-minute basis.
Some brokers also offer the option to purchase fractional shares of a stock or ETF. When you purchase fractional shares, you get to decide how much you’ll invest in dollars, with minimums as low as $5. For example, if a certain ETF is trading at $100 but you can only invest $20, a broker offering fractional shares will sell you 0.2 shares of the ETF with your $20 investment. This makes ETFs even more accessible, especially for new investors.
Types of ETFs
There are various types of ETFs, which can each be used strategically to meet varying investing goals.
Equity ETFs
Equity ETFs are a type of ETF that invests most of its funds in stocks. Many equity ETFs are also index funds, meaning that these are the most common type of ETF. Some equity ETFs are industry-specific, investing primarily in assets in a particular industry or sector. For example, the iShares U.S. Technology ETF (NYSE: IYW), a technology sector ETF, invests more than 30% of its total assets into Apple and Microsoft.
Bond ETFs
Bond ETFs, by contrast, invest in fixed-income securities like government or corporate bonds. These bonds essentially function as loans to the underlying party, with the promise that you will receive the full value of the bond plus interest on the date of maturity. Because the bonds are guaranteed to return the initial value, bond ETFs provide more stability than equity ETFs. but also offer less opportunity for growth.
Commodity ETFs
Commodity ETFs are a unique type of asset that invests the majority of funds into physical commodities like gold, silver, oil, or agricultural products. The value of the ETF varies depending on demand for the underlying commodity. Some commodity ETFs invest in futures contracts in lieu of the physical commodity. These types of commodity ETFs usually charge lower fees because no considerations need to be made for product movement.
Key Differences Between Mutual Funds and ETFs
Now that you understand the basics of mutual funds and ETFs., let’s take a look at a few important differences between them.
- Trading: ETFs are traded throughout the day like stocks — you can buy and sell them multiple times a day if you want. Mutual funds are bought or sold directly through a fund company or broker, who executes the transaction at the Net Asset Value (NAV), which is calculated at the end of each trading day. This is the only time when mutual funds are bought and sold.
- Management: Mutual funds are typically actively managed by professional fund managers, while most ETFs are passively managed and designed to track an index.
- Fees: Mutual funds typically have higher fees, including expense ratios, and sometimes load fees, than ETFs.
- Investment Minimums: The minimum investment for an ETF is the price of one share, which may change throughout the day, while mutual fund minimum investments vary depending on the individual fund and the managing company or broker that offers the fund.
- Tax Liability: ETFs are usually more tax advantageous than mutual funds. If your ETF is held in a taxable account, you’ll only pay taxes when you sell the fund at a profit. Some investors strategically take net losses on taxable ETF sales to offset gains using a strategy called tax loss harvesting. Mutual funds may trigger capital gains taxes due to manager activity and fund distributions. Even if you've never sold your mutual fund shares, if the sale of an asset results in a capital gain, the taxes are split among all shareholders.
Are ETFs Better Than Mutual Funds?
ETFs and mutual funds both pool money from investors to purchase a defined series of assets, which may include stocks, bonds, commodities, and more. ETFs are a more popular option for most investors thanks to their lower minimum investments, simpler trading process, and more affordable pricing. However, mutual funds come with the benefit of professional management, which can make them more suitable for long-term strategies. Overall, ETFs tend to be a better option if you’re looking to actively trade and want more control over your investments, while mutual funds are better for hands-off investors looking to save for a goal like retirement.
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