Mutual funds and ETFs are popular investment vehicles for people investing in the passive industry. In the US, active and passive ETFs and mutual funds have assets that are close to $20 trillion. Most of these funds are in actively-managed mutual funds, which has more than $11.8 trillion. Passive index fund and ETFs have more than $3.6 trillion each. While these investment vehicles are popular, a good number of investors don’t know the difference between the two. In a research of 1,000 investors, 17% don’t know the difference between the two. This article will look at the mutual funds and ETFs, explain what they are, and their differences.
What is a Mutual Fund?
Going by the name, a mutual fund is formed by two words. In short, a mutual fund is formed when two or more people pool their resources together with the goal of investing in various assets. After pooling the resources together, a portfolio manager is selected, and is tasked with making investments. These investments can be money market funds, balanced funds, fund of funds, and equity funds among others. The mutual funds are usually run by large companies like Vanguard, Fidelity, and Blackrock. There are two broad types of mutual funds. There are active, where the portfolio manager usually makes investment decisions and a passive fund that tracks an existing index.
What is an ETF?
An ETF is a short form of an Exchange Traded Fund. As the name suggests, an ETF is a fund that is usually traded in an exchange. As a result, the share price of an ETF usually fluctuate during the trading day. To form the ETFs, companies usually buys the stocks and then list them to an exchange. As a result, buying an ETF is done in a similar way as buying a stock. The most common types of ETFs are Bond ETFs, Industry ETFs, Commodity ETFs, Currency ETFs, and inverse ETFs.
Mutual Funds vs ETFs
As shown above, the ETFs and mutual funds are usually similar. However, there are a number of differences between the two.
First, as explained, ETFs are traded in an exchange. As a result, you can easily buy and sell the ETF when the market is open. However, traditional mutual funds can only be bought and sold once in a day when the market closes. This means that with ETFs, investors can easily react to new news when they emerge. For long-term investors however, owning a mutual fund is usually good because you won’t be reacting to daily market action.
Second, there is a difference in the cost structure of the ETFs and mutual funds. As mentioned, since ETFs are listed in exchanges, the only cost that you pay is the commission to your broker. This differs from one firm to another but on average, they are usually lower than $5 per trade. There are new companies like Robinhood that don’t charge a commission. In addition, expense ratios for ETFs are usually lower than those of active mutual funds.
Mutual funds on the other hand have their own costs. The first cost is known as a load. Loads usually range between 1% to 2%. The loads pay the brokers for recommending you to their funds. In addition, the portfolio manager and the investing team are paid in two ways. They can be paid an annual percentage of the portfolio, which ranges between 0.5% and 2%. The second cost is the expense ratio. This is the percentage of of assets paid to run the fund. Finally, there is the 12b-1 fee, that is usually part of the expense ratio. This can run up to 0.25% in a front-end load and 1% for a back-end load fund.
Third, in actively managed mutual funds, the investment team has the discretion of selecting the assets they will invest in. The fund’s prospectus usually has the specifications in which the fund manager can make the decisions. On the other hand, in ETFs, there is usually no flexibility on the investments they can make.
Fourth, when it comes to taxes, mutual funds and ETFs are different. In general, ETFs are usually considered to be more tax efficient than mutual funds. This is because ETFs usually have their unique way of selling and buying the assets. This is because they use creation units, which allow for the buying and the sale of assets in the fund collectively. Second, most ETFs are usually passively managed, which reduces the taxable transactions. Mutual funds on the other hand have more taxes because they tend to generate higher capital gains because of the actions of the management. Further, managers must always buy individual securities in a mutual fund when accommodating new shares.
Final Thoughts on Mutual Funds and ETFs
Mutual funds and ETFs are popular ways to invest in the financial market. Since they are all made up of diversified portfolios, they tend to generate fewer returns than single stocks. However, in the long term, this diversification helps to hedge against the weak performance of several assets. As you start to invest in the two, we recommend that you own both ETFs and mutual funds. You should also invest in them for the long-term, and not for the short term gains.
Kasper is our expert for saving, investing and bank accounts. Kasper holds an MSc in Mathematics and worked with Mercedes-Benz and the Dutch tax authorities.