Many investors prefer to invest in funds over individual stocks, bonds, and other assets because they provide diverse market exposure. If this is the investment route you would like to follow, one of the most important decisions you’ll make is whether to invest your money in exchange-traded funds (ETFs) or mutual funds.
ETFs and mutual funds have a lot in common. For instance, they are both made up of a mix of many different assets – representing an increasingly popular way for investors to diversify their portfolios, and they both give investors exposure to a broad range of markets, regions, niches and asset classes without requiring them to buy loads of individual stocks.
Interestingly, Robert Armstrong (a BMO investment strategist) predicts that every mutual fund will soon be available as an ETF and that the two are slowly merging into one.
However, while the two investment vehicles share some obvious similarities, there are also several important structural differences between them that investors should explore before determining which one is right for them.
This article will consider these similarities and differences and help you decide which investment vehicle will best help you reach your goals.
- What are ETFs?
- What are mutual funds?
- So, how are ETFs and mutual funds different?
- So, ETFs vs mutual funds, which one is right for you?
- Interested in ETF investing? Meet arty!
What are ETFs?
An ETF is an investment fund that invests in a collection of stocks, bonds, commodities or other assets all in one go. Similar to stocks, they are traded on a stock exchange and can be bought and sold throughout the day. Their objective is to mirror the performance of a specific index, such as the S&P 500, and are often passively managed.
ETFs attract investors because they provide access to virtually every asset class, region, sector, niche, and investment style. They also offer low fees, transparency, ease of trading, tax efficiency, and diversified exposure to the markets.
The ETF market has developed significantly since the first ETF was established in 1993. As of 2020, ETFs manage around $7.74 trillion in assets globally. Furthermore, PwC have predicted that by 2025, the global ETF industry will grow to over $12 trillion in assets under management. This is no surprise, as it is an industry with enormous potential.
What are mutual funds?
Mutual funds, just like ETFs, are a form of financial vehicle that invests in securities such as stocks, bonds, and other such assets by pooling assets together. They also have similar diversification benefits to ETFs. However, unlike ETFs, they are actively managed by professional money managers, who allocate assets in an attempt to generate capital gains or income for the fund’s investors.
So, how are ETFs and mutual funds different?
While the two investment vehicles share some similarities, there are key differences between them regarding how they are managed, minimum investment amount, fees, diversification, tax implications, transparency, and more. Let’s look at these in more detail.
1. How they’re managed
Management is generally divided into two categories: active and passive. Most mutual funds are actively managed and aim to outperform market indices. Fund managers will analyse the market and draw upon their own investment experience in order to maximise the fund’s performance.
Passive funds, on the other hand, aim to match their performance to that of a market index, such as the FTSE 100. The performance of a passive fund is determined by how well it mirrors the index it is following, and it will not have a management team behind it making investment decisions. Most ETFs fall into this group.
It’s important to note that some mutual funds – like index funds – can be passively managed, and some ETFs can be actively managed, so don’t always assume the management strategy based on the fund type. Make sure you read the prospectus of the fund so your decisions are well informed. But, overall, the majority of ETFs you come across will be passively managed, and mutual funds will be actively managed.
2. How they’re traded
Another distinction between ETFs and mutual funds is the manner in which the funds are traded, which can impact investors.
While ETFs are traded at the current market price throughout the day like stocks, mutual funds are bought and sold directly from mutual fund companies at the day’s current closing price – this is known as the net asset value, or NAV. ETFs, therefore, can fluctuate in price and cost slightly more or less than the NAV, which stays the same.
There are two kinds of fees to keep an eye on with all funds: transaction fees and expense ratio fees.
With mutual funds, transaction fees might include sales charges or redemption fees, which are paid for directly by investors. ETF transactions, on the other hand, may include brokerage fees, as is the case with stock trades.
An expense ratio represents the operating costs of a fund divided by the average dollar value under management as of the fund’s fiscal year end. The expense ratio is calculated annually and reported in the fund’s prospectus. The most significant aspect of these costs will usually be the management fee.
Out of the two, ETFs are the lower-cost option. The average expense ratio for this type of fund can be as low as 0.05% (e.g. Vanguard), but with the rise of zero-commission brokers, the fees for ETFs are largely evaporating.
Mutual funds have a considerably higher fee structure. As per a study done by the Investing Company Institute, the average mutual fund expense ratio as of 2020 was 0.71%. While the cost of these funds has decreased dramatically in recent decades, they are still significantly more expensive than ETFs. This can easily be explained – as stated, most mutual funds are actively managed, which means the higher fees are a result of the increased amount of work involved in managing the fund’s assets.
4. Initial investment
The minimum investment amount needed to invest in a fund is an important factor to consider, especially for beginners.
For an ETF, the initial investment amount is the market price can be as little as one single share, making them extremely accessible to all types of investors.
Mutual funds are less accessible, especially for beginners. The majority require thousands of dollars as a minimum investment.
Most investment-grade funds are highly diversified – investing in a variety of assets in order to create high returns for their investors. However, there is one subtle difference to consider.
ETF diversification is based upon how diversified the underlying index is. For instance, an S&P 500 fund could have around 500 stocks listed on the index, and a Nasdaq Composite fund could consist of around 3000 stocks.
On the other hand, mutual funds require the oversight of a management team to ensure everything remains consistent with the fund’s investment plan, so while they are well-diversified, they aren’t as diversified as ETFs. This is because the manpower needed to actively manage and trade even 500 stocks – let alone 3000 – would be extremely hard to achieve without algorithmic monitoring.
Access to information about which stocks, bonds and other assets contained in your fund is referred to as transparency.
ETFs will generally reveal their holdings on a daily basis, and because they track a specific index, there is great transparency when it comes to the securities owned.
Mutual funds buy and sell securities at different times and in different amounts. Thus, their holdings will change over time. Furthermore, mutual funds are only required to report their holdings on a quarterly basis.
7. Tax implications
It is important to consider the tax implications of your investments. As a result of being passively managed, the assets in ETFs are rarely traded, meaning they are a tax-efficient investment option. Trades are only made when an underlying benchmark’s listings change. The majority of assets held within an ETF will typically be kept for longer than one year, resulting in reduced rates when the assets are eventually sold.
The majority of mutual funds are actively managed, which implies that trades are made on a regular basis. Depending on the fund’s investment strategy, multiple trades within a mutual fund may occur in a single trading day. This results in short-term gains, which means they will be taxed at your standard income tax rate.
So, ETFs vs mutual funds, which one is right for you?
At the end of the day, it’s all about your personal investment goals.
Choose ETFs if:
- You’re new to investing and have a lower account balance.
- You’re cost-conscious and want a low-cost exposure to the markets. ETF trades are usually commission-free, and often have low expense ratios.
- Tax efficiency implications are a significant factor.
- You wish to pursue a long-term investing strategy but have no interest in active management and picking ‘winners’ and ‘losers’.
Choose mutual funds if:
- You have more money to put into the market. To start investing in mutual funds, you’ll have to pay a high price – often in the thousands. You’ll also have to factor in transaction fees. These funds are suited to investors with more substantial investment portfolios.
- You’re willing to pay for the expertise. Mutual fund investors understand the benefit of having professionals manage their money, and they are willing to pay for it.
- You prefer active management and value the possibility of outperforming the market. While there are a few actively managed ETFs out there, the majority of ETFs simply track an index. If you want to outperform an index, active management is necessary.
- You are willing to take more risks. Mutual funds are great for investors who are ready to take on more risk in exchange for higher returns.
Keep in mind that you don’t have to choose one or the other. If you can afford to, investing in both is a great way to build wealth and increase the returns of your overall portfolio while keeping it diversified and at low risk.
Interested in ETF investing? Meet arty!
If you want to optimize your investment portfolio with ETFs, arty is here to help. Since 2016, arty has generated annualized returns of up to 30% over various portfolios, which you can copy based on your personal investment goals. arty offers you custom portfolios to choose from based on your preferred level of risk and desired target return, which you can then copy to your own brokerage account. It uses the latest AI technology to choose the most optimal allocations for your portfolio each month.