On the surface, the difference between a mutual fund and an ETF may not seem so significant. But these products serve different needs. In this article, we’ll take a look at how both these investment tools work and what considerations you should have before settling on a given fund. So, let’s look right into what is the difference between a mutual fund and an ETF.
What’s the Difference Between a Mutual Fund and an ETF?
I recommend that people invest some portion of their money in the stock market. As a wealth building tool, stocks have a proven track record for growth over the long term. And, one of the easiest, most cost-effective ways to invest in the stock market is through mutual funds and exchange-traded funds (ETFs).
The appeal of these products is that they are managed portfolios. The financial experts in charge of these funds have the expertise, knowledge, and tools at their fingertips to make informed investment decisions. So, they do all grunt work while you sit back and enjoy the returns at a (hopefully) reasonable cost.
Like mutual funds, ETFs are a pool of assets – mostly stocks and/or bonds. But, there are fundamental differences between mutual funds and ETFs. These differences can affect how much money you make and when you make it. Since ETFs and mutual funds come with their individual sets of benefits and drawbacks, it’s important to understand the key differences between them and how to use them to your best advantage.
But, first, let’s delve a little more into how these two investment products are similar.
The Similarities Between a Mutual Fund and an ETF
Both mutual funds and ETFs are diversified investments that enable investors to buy into a collection of investments. The collection of investments, known as a portfolio, is comprised of stocks or bonds and sometimes the two together. Oftentimes, ETFs and mutual funds will consist of a particular group of stocks or bonds, such as large-cap stocks or short-term bonds. But there are also broad, all-encompassing ETFs and mutual funds like the Total World Stock Market or the Aggregate US Bond Market, for example.
Most ETFs operate like an index mutual fund in that they are passively managed. In other words, relatively little securities trading activity happens within these funds. Instead, their makeup and performance will closely follow a particular index, such as the Dow Jones Industrial Average or the S&P 500. Both ETFs and mutual funds tend to be much less expensive than actively-managed funds.
The sum total to all of this is that ETFs and mutual funds are attractive investment options for portfolio diversification and stability as well as building wealth. But, before you settle for one type of fund or the other, you should be aware of how they differ.
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The Difference Between a Mutual Fund and an ETF Explained
One primary difference between a mutual fund and an ETF is the way in which investors buy and sell them. ETF funds, in general, offer more flexibility than mutual funds since you can easily and quickly buy and sell them in the market. Much like a common stock, you can purchase or sell an ETF at any point during normal trading hours at the current market price. ETFs also allow you to use a variety of buy or sell orders that specify when and under what conditions a trade can take place. This is important because it gives you control over the transaction. You could, for example, restrict a transaction by price, or set a specific time during which the trade can happen.
Mutual funds, on the other hand, come with a number of limitations. For example, some mutual funds have a minimum holding period of at least 90 days. If you try to sell shares before that time, you’ll have to pay a penalty fee. Plus, trading a mutual fund doesn’t happen right away. Unlike ETFs, mutual funds trade only after the markets close for the day. If you make a request to buy or sell, your trade will be priced at the next available net asset value, which is generally calculated and posted about two hours after the market closes. And, as you may have guessed, the ability to specify the conditions under which mutual fund shares are bought or sold also does not exist.
In addition, many mutual funds have a minimum initial investment amount. It can be as little as $500 for some funds and in the thousands of dollars for other mutual funds. To get started with ETFs, the initial investment amount is as little as the price of a single share. So ETFs make a lot of sense for smaller investors and those investors who are just getting started,
Here are some other key differences between an ETF and a mutual fund:
With the exception of the index mutual fund, ETFs are passively-managed, whereas mutual funds tend to be more actively managed. With less management comes fewer fees and that generally makes ETFs a lot less expensive to own than most mutual funds.
The ETF is more tax-friendly since there is less internal trading, known as turnover. When there are fewer trades, there are fewer transactions that can are taxed. You are taxed when you decide to sell the ETF. Mutual funds, however, are actively managed and will offer you taxable income whether or not you sell any shares. The only time this is avoided is if your mutual fund is part of a tax-deferred retirement account, such as a 401(k), RRSP or Superannuation.
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Index Funds, ETFs or Both: Which is Right for You?
Now that you know the difference between a mutual fund and an ETF, which should you choose? The truth is that ETFs and mutual funds each fill different needs.
- ETFs are a great option for investors who want a simple, stable, easily accessible, yet cost-effective solution that will help them build real long-term wealth.
- Mutual funds, on the other hand, are great for investors looking for an actively managed basket of securities. This is particularly effective if they want to target a specific market niche or they want to invest in securities that are less well-known or obscure.
Many investors include both ETFs and mutual funds in their portfolios as complementary investments. Either way, ETFs and mutual funds should both be considered as an important part of your investing and wealth building strategy.
Special Note for US Expat Investors (like me): mutual funds and ETFs issued outside the United States qualify as Passive Foreign Investment Companies (PFICs) for US tax-reporting and taxation. You should avoid owning these investments in your portfolio. Investment alternatives that you can buy free of punitive taxation include mutual funds and ETFs issued in the United States and individual securities issued both inside and outside the US, among others. For more information, take a look at the articles here, here, and here.
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