When constructing an investment portfolio, you’ll probably include a variety of stocks and bonds among the securities you purchase. Stocks and bonds can be purchased individually or as part of a bundle of securities known as a mutual fund or an exchange traded fund (ETF).
Buying securities this way offers several potential advantages to investors — one of the biggest being instant diversification because mutual funds and ETFs contain not just one security, but many different individual securities. Funds are also run by professional portfolio managers, so investors have the benefit of expert management. But what is the difference between these two investment vehicles? They are often conflated, so we break down the similarities and differences.
A Fund by Any Name?
Some people wonder whether mutual funds and ETFs are just different names for the same type of investing, or if they are different altogether. While there are similarities, they aren’t the same thing.
First, the similarities: Both mutual funds and ETFs consist of a basket of many different individual securities pooled together. So when you buy shares in a fund, you are effectively buying the shares or investing in the debt of hundreds, or even thousands, of different companies.
How Are ETFs and Mutual Funds Different?
Like individual stocks, ETFs are listed on the major stock exchanges. Therefore, you must have a brokerage account in order to buy and sell ETFs. Conversely, shares of mutual funds are traded directly with the fund company, so no brokerage account is necessary in order to buy and sell. You can simply place trade orders with the fund company or your financial advisor.
With ETFs, there is a bid price and an ask price — the price paid is usually somewhere between these. For example, suppose you want to invest $5,000 in an ETF at a final price of $45 a share. You’d need to place an order for 111 shares (111 x $45 = $4,995).
ETFs are traded throughout the day, just like stocks, with their prices fluctuating all day long. As a result, they generally offer more trading flexibility as well as greater transparency.
Mutual funds, on the other hand, are priced after the markets have closed at the end of the day when the fund’s net asset value (NAV) is calculated. So if you wanted to invest $5,000 in a mutual fund priced at $45 a share, you’d simply place a $5,000 order and receive approximately 111 shares at the end of the trading day.
ETFs are index funds that are passively managed. While some mutual funds are also passively managed index funds, others are actively managed. As a result, ETFs usually feature lower expenses than mutual funds, which can result in higher after-tax returns. According to the Investment Company Institute (ICI), the average expense ratio of index ETFs is 0.21% while the average expense ratio of actively managed mutual funds is 0.78%.
ETFs also tend to be more tax-efficient than mutual funds due to their low turnover, which minimizes taxable capital gains distributions. ETF securities don’t have to be sold in order to meet redemption requests from investors. This isn’t the case with mutual funds, where these redemptions may generate taxable gains.
So which type of investment would be best for you — a mutual fund or an ETF? It depends on several different factors.
For example, if you prefer active instead of passive investment management, you’ll probably want to choose mutual funds since all ETFs are passively managed. But if minimizing expenses and taxes is important to you, then ETFs might be the better choice.
In a diversified portfolio, there may be a place for both mutual funds and ETFs. You should speak with your financial advisor about which type of investment is better suited to your investment goals and objectives.
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