Mutual fund and exchange-traded fund (ETF) investing has increased substantially in recent years. Investors recognize the convenience of investing in these vehicles rather than trying to make it on their own. Both are diversified, professionally managed portfolios of assets that can contain hundreds or even thousands of stocks and bonds. But that’s where the similarities end. Let’s take a closer look at the differences between these two investment vehicles and decide what’s worth your time and money.
- Management Fees. Mutual fund management fees can vary greatly, depending on whether the fund is actively or passively managed. Actively managed funds typically charge a fee between 1 and 3 percent, while the fee for passively managed funds is usually less than 1 percent. In most cases, ETFs have lower fees than both active and passive mutual funds.
- Transaction Costs. There is generally no upfront cost to purchase a mutual fund, although you may be required to hold the fund for a certain length of time before selling it. In contrast, you will have to pay commission to your brokerage whenever you purchase an ETF.
- Minimum Investment. The minimum investment for ETFs is the cost of one share. Mutual funds generally have a minimum initial investment of at least $1,000, although there may be no restrictions on subsequent purchases.
- Liquidity. You can buy or sell an ETF any time the market is open. The liquidity of an ETF will depend on how widely it is traded by investors. Popular ETFs are very liquid and can be traded with a minimal bid-ask spread, while thinly traded ETFs can take longer to sell. In contrast, mutual funds can only be bought or sold at the end of the trading day, and depending on the fund and when it was purchased, you may be charged an early redemption fee.
- Reinvestment. Mutual fund distributions can either be paid out as cash or used to purchase additional units of the fund. ETF distributions can only be paid out as cash, unless your brokerage offers an automatic reinvestment plan. Even if that is the case, you may be charged additional commission and the trade will take at least three business days to settle, costing you valuable time in the market and potential missed dividends.
- Flexibility. ETFs offer much more flexibility than mutual funds do. You can buy and sell ETFs at any time during the trading day, whereas mutual funds are priced daily after market close, so day trading is impossible. Active investors can also pursue advanced strategies with ETFs, such as buying on margin, short selling, or options trading.
- Tax Efficiency. ETFs are fundamentally structured more tax efficiently than mutual funds. Mutual funds are structured such that its shares are purchased and sold to the mutual fund company. This causes mutual funds to realize more taxable events than ETFs do. When an investor withdraws from a mutual fund, the fund must sell a part of its holdings to generate cash for the withdrawal. Any capital gains realized from this sale will be passed on to the remaining investors in the form of a taxable distribution at the end of the year. In contrast, ETF shares are traded between investors so no liquidation is required to accommodate the sale. Generally, an ETF will only replace one if its holdings if there is a corresponding change in the underlying index.
Bottom Line
There is a place for both mutual funds and ETFs in the market. For active investors who like to day trade or employ advanced strategies, ETFs are the way to go. For passive investors who prefer to buy-and-hold, it depends. If you like making regular contributions to your portfolio, then mutual funds are preferable because there are no transaction costs and distributions can be automatically reinvested. But if you like making large investments as a lump sum, ETFs are superior due to their lower management fees and more tax efficient structure. As the market for mutual funds and ETFs continue to grow, investors only stand to benefit from a greater product selection and more competitive pricing.