Mutual Funds vs. EFTs: A Guide
Posted by Frank Gogol
Updated on August 2, 2022
The financial industry can be confusing for new investors or when investing for H1B visa holders. Many investment-related concepts are unfamiliar. Among these is the concept of pooled investments like ETFs and mutual funds. Understanding the difference between ETF vs mutual fund is important for understanding which investment is best for your needs.
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ETFs vs. Mutual Funds
Exchange-traded funds (ETFs) and mutual funds are types of investment products. They represent a way to invest in many different financial instruments at the same time. The two are quite similar but work in slightly different ways.
What Is an Exchange-Traded Fund (ETF)?
An exchange-traded fund is a type of investment that combines investments in a lot of other financial assets. These assets could be stocks, bonds, or derivatives. Exchange-traded means that shares of the fund can be bought and sold directly by any trader on the stock market.
ETFs are generally structured so that they follow the ups and downs of a particular economic index (e.g. S&P 500), industry (e.g. medical device manufacturing), or commodity (e.g. corn).
The way this is done is that the fund itself is a company that purchases hundreds of financial assets. Shares of this company (the ETF) are then made available to investors.
As the value of all the assets that the EFT holds increases or decreases, then the value of any investment in the ETF also increases or decreases.
What Is a Mutual Fund?
Most mutual funds are actively managed. This means the allocation of money to various assets is managed daily by financial professionals called money managers. The goal of a money manager is to maximize the value of the mutual fund’s assets in the long term and minimize losses in the short term.
Unlike ETFs, mutual funds are structured and managed to achieve the performance stated in their investment prospectus.
A mutual fund prospectus is a document that states the objectives of the fund and other details. This document is made available to potential investors so they can use it to compare various mutual funds and choose the one that suits their investment goals.
What’s the Difference?
Although both kinds of investments effectively ‘pool’ hundreds or thousands of different financial assets, there are some important differences between ETFs and mutual funds. See below for a comparison of ETF vs mutual funds.
Most mutual funds are actively-managed. A professional fund manager trades assets on the stock exchange daily, attempting to maximize the fund’s value. Active management comes with higher fees for investors. On the other hand, most ETFs are passively-managed, meaning they follow the ups and downs of a pre-selected economic index or commodity. In the long term, passively managed funds tend to outperform actively-managed ones.
The management fees associated with a fund can vary from 0.15% to 1% of the money you invested. Actively-managed funds usually attract higher fees.
There are also several other costs, such as brokerage commissions, or early redemption fees. It is important to understand all the costs associated with your potential investment before you commit any money.
A key difference between ETFs and mutual funds is that you can buy and sell shares of an ETF on a stock exchange throughout the day. However, it is only possible to trade a mutual fund once a day, at the end of trading.
In general, ETFs are more tax-efficient than mutual funds. That means your investment will attract lower federal taxes in ETF vs mutual funds. Actively-managed mutual funds tend to attract higher capital gains taxes because the assets in them are bought and sold frequently.
Whenever the assets in the fund are sold for a gain, every investor in the fund is liable for part of the capital gains tax, even if they did not sell their shares. ETFs passively track a pool of assets with no trading, so you only pay capital gains tax if you choose to sell your shares.
Generally, mutual funds have a higher minimum investment than ETFs. The minimum investment is the smallest amount of money that you can invest in a fund. Many mutual funds have a minimum investment of several hundred or even one thousand dollars or more. On the other hand, individual shares of an ETF may cost only a few dollars.
ETFs or Mutual Funds?
When you decide to invest, don’t assume that a given investment is the best or lowest-cost option just because it is passively managed. It is important to look at all of the fees associated with a fund, not just the management fees when making your decision.
The best way to make the decision is to understand what your investment goals are, then look for a product that matches your goals. When thinking about your investment goals, consider the following factors among others:
- How much you can invest upfront
- Whether you want to add to your investment over time
- How long you are willing to let your investment grow
- If you are willing to accept losses in the short term
- How much investment risk you are willing to accept
If you are not familiar with the financial sector, this can be a difficult decision to make. Consulting a licensed fiduciary financial advisor can help you understand things better.
When to Choose ETFs
Choosing between ETF vs mutual fund depends on your investment goals and how familiar you are with the stock market. Read below to learn about the situations in which ETFs might be the best choice for you.
If You’re an Active Trader
Exchange-traded funds are sold as shares on the stock exchange. This means you can perform the same transactions on your mutual fund investment as with individual stocks.
These transactions include:
- intraday trading
- stop orders
- limit orders
If you are a day trader and you want to have exposure to hundreds or thousands of assets all at once, an appropriate ETF is probably a good choice for you.
If You’re Tax-Sensitive
Passively-managed funds do not attract the potential capital gains taxes that arise from frequent daily buying and selling of assets in the fund. This means that an ETF is likely to cost you less over time in terms of capital gains taxes than a similar actively-managed mutual fund.
When to Choose Mutual Funds
Choosing between ETF vs mutual fund depends on your investment goals and how familiar you are with the financial industry. Read below to learn about the situations in which mutual funds might be the best choice for you.
If You Invest Regularly
If you want to be able to add to your investment, an appropriate mutual fund product may be the best choice for you. For example, if you want to be able to invest a set portion of your salary every month.
If Similarly ETFs Are Thinly Traded
If you want to trade shares in an ETF, your transaction is subject to a quantity called the bid/ask spread. This is the difference in price between the actual value of the share and what a buyer is willing to pay.
For ETFs that are frequently traded this difference is often small. However, for ETFs that are rarer, the bid/ask spread could become significant.
On the other hand, mutual fund shares are always traded at their full value. Thus if you are willing to slow your trading volume to once a day, then a mutual fund could be a better choice for you as a trader than a similarly structured ETF.
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When deciding between ETFs and mutual funds, the most important thing is to understand what your investment goals are. Then you can choose which investment product suits you better. ETFs and mutual funds are pools of numerous different financial assets. As the value of the assets in the fund changes, the value of the fund changes. ETFs tend to be passively traded, and thus less costly.
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