Mutual funds and ETFs both offer investors a way to invest via a professionally managed fund. It’s important to understand the differences between these two investment vehicles when deciding which is better for your situation.
What is a mutual fund?
A mutual fund is a pooled investment vehicle that is professionally managed. Many investors invest various amounts of money into the fund. Investments can be made on a one-time basis or at various intervals over time.
Mutual funds invest the fund’s assets according to the investment objective stated in the fund’s prospectus. They might invest in stocks, bonds, a mix of the two or in money market instruments. Mutual funds might invest actively, this means that the manager makes an affirmative decision to buy, sell or hold certain securities within the fund’s investment objective. They might also invest passively trying to replicate the performance of an index such as the S&P 500.
Mutual fund investors invest a dollar amount into the fund which will purchase the number of full and fractional shares covered by that dollar amount. Mutual fund shares are purchased and sold at the end of the trading day.
What is an ETF?
ETF is the acronym for exchange traded fund. An ETF is like a mutual fund in that they are pooled investment funds that invest in various securities such as stocks, bonds, commodities and other types of securities.
The major difference between ETFs and mutual funds is that shares of ETFs are bought and sold on the stock exchange during trading hours much like shares of individual stocks. ETFs can be purchased via a broker or directly online via most custodian platforms.
Pros and Cons of Mutual Funds and ETFs
There are a number of similarities and differences between mutual funds and ETFs. This gives rise to a number of pros and cons of each as well. Here are some of the pros and cons of mutual funds and ETFs.
Mutual fund pros
- Professional management. Mutual funds offer professional management of the fund’s portfolio. Actively managed funds offer specific portfolio strategies in terms of specific stocks or bonds held in the fund. Managers of passive index funds ensure the fund replicates the performance of the underlying index as closely as possible.
- Dividend and capital gains reinvestment. Mutual funds allow for the reinvestment of dividend, capital gains and other distributions. This allows this money to grow and compound over time.
- Diversification. Mutual funds generally hold a number of securities within the fund’s investment objective. Even within a narrow investment style, mutual funds offer diversification by holding a number of different stocks or other securities that match the fund’s investment style.
Mutual fund cons
- Tax inefficiency. Mutual funds can be very tax inefficient due to the fact that investors have no control over the timing and the amount of distributions for dividends and capital gains. This can result in unwanted income if the fund is held in a taxable investment account.
- High expenses. Some mutual funds, generally funds that use active management, can have high fees and expenses. These high fees can eat into your returns over time.
- Diversification. ETFs provide an efficient way to diversify your portfolio. ETFs are offered in a variety of major asset classes including stocks, bonds, domestic and international. For stocks there are broad index ETFs as well ETFs that focus on specific sub-asset classes and sectors. There are a wide range of bond ETFs offered as well.
- Low cost. ETFs are generally low cost due to their structure. ETFs are often lower in cost than mutual funds with a similar investment objective.
- Liquidity. ETFs are traded during the trading day, the same as shares of individual stocks.
- Transparency. Unlike mutual funds, ETFs must disclose their underlying holdings on a daily basis.
- Tax efficiency. Due to their structure, ETFs are generally more tax efficient when compared to mutual funds.
- Some brokers and custodians may charge a commission to buy or sell shares of an ETF.
- Bid/ask spreads. This is the spread between the price a buyer is willing to pay for a share of the ETF and the price at which a seller is willing to sell shares. Many widely traded ETFs have a very narrow spread, others that have less trading volume may have a wider spread. The wider the spread generally the more expensive it is to trade the ETF.
- Premiums and discounts. The market price of an ETF is a function of the share price as determined by traders during the trading day. This price might be above the underlying value of the securities, meaning you will pay more than the net asset value per share, in other words you will pay more than the underlying holdings of the ETF are worth.
Do ETFs outperform mutual funds?
The answer to this question is that it depends, and an investor needs to look at a particular mutual fund versus a particular ETF they might be considering.
If you are looking at an index mutual fund that tracks an index such as the S&P 500 compared to an ETF that tracks the same index, their performance in both the short-term and long-term will be very comparable. The only real difference will be based on the expense ratios, the fund with the lower expense ratio will slightly outperform.
In general, many but not all ETFs tend to have lower expense ratios than mutual funds. This is inherent in their structure. If you are looking at an ETF compared to a mutual fund in the same asset class the answer might skew towards the ETF over time.
In part this is because many ETFs invest on a passive indexing basis. If you are comparing this to an actively managed mutual fund in the same asset class, the mutual fund might outperform over certain time periods when the manager’s investment style and stock picking happens to be in sync with the markets. Over time, however, their investment style might lag. This and the combination of higher expenses would likely lead to the ETF outperforming over a longer time frame.
Mutual funds or ETFs which are better?
Again the answer to this question is that it depends on each investor’s situation and their goals.
ETFs allow for trading while the stock market is open and are a good alternative for investors who look to trade actively. They offer generally low costs and in some cases access to investment styles not available in a mutual fund format.
For those seeking active management, a mutual fund is the better choice as actively managed ETFs are not very prevalent. Mutual funds are also a good option for those looking to invest a set amount of money on a regular basis as they are purchased in dollar amounts versus the number of shares as with ETFs.
Both ETFs and mutual funds offer a professionally managed investing vehicle for investors. Which one is best will depend upon the investor’s own unique situation. It’s important for investors to understand the pros and cons of each type of security when deciding where to invest.