Mutual funds vs. ETFs is an issue that has plagued investors since the introduction of exchange-traded funds in 1993, and there are important differences between the two you should know to help make a decision about which is best for your portfolio.
Regardless of whether you are a rookie or more seasoned, as an investor, you’re faced with a lot of choices when it comes to where to put your money.
But some of the more popular investments, such as mutual funds vs. ETFs, provide a potential dilemma.
And there is no easy answer to the question of which is the best investment for you. It all comes down to preference and strategy.
So we’ll look at what mutual funds and ETFs are and point out the differences to help you decide which is the best direction for you.
What is a Mutual Fund?
First, you need to know exactly what a mutual fund is.
Essentially, they are investment strategies that pool money together from different investors to purchase a set of stocks, bonds or other securities.
The price of the mutual fund is used by taking the total value of the securities in the fund and dividing that by the fund’s outstanding shares, known as the net asset value. It fluctuates based on its value at the end of every business day.
One thing to note is that if you invest in a mutual fund, you don’t actually own shares in the companies in the fund. Rather, you own shares of the fund itself.
If you buy into a mutual fund, you don’t decide when to buy or sell the securities inside the fund. That decision is made by the portfolio manager.
What is an ETF?
We’ve talked about investing in ETFs before, but let’s do a quick refresher on exactly what they are.
Essentially, they are just like stocks. They can be traded on the market, but they allow you one thing that individual stocks don’t — instant diversification.
An ETF is a bucket of equities that will track an underlying index. Instead of just one stock, ETFs can hold hundreds of stocks across different industries.
They are similar to mutual funds, only they are listed on exchanges and shares of ETFs trade just like any other stock.
For example, the most popular ETF is the SPDR S&P 500 ETF (NYSE: SPY). It tracks the S&P 500 Index. Its holdings include Apple Inc. (Nasdaq: APPL) and Microsoft Corp. (Nasdaq: MSFT).
If you were to invest in SPY, you would be diversifying your investment into all the different holdings that ETF has. To check the performance of your money, however, you only need to see how SPY is performing, not each individual stock inside it.
Mutual Funds vs. ETFs: What’s Best For You?
There are several pros and cons to both types of investments.
ETFs are typically cheaper than mutual funds when it comes to expenses. According to Investment Company Institute research, the average expense ratio in 2019 for an ETF is 0.18%, compared to 0.54% for a mutual fund.
Mutual fund fees are higher because you are essentially paying a fund manager to actively handle the fund. With ETFs, you handle the investments yourself. If you are a more seasoned investor, that’s not an issue. But if you are more of a novice or hobby investor, having someone do the leg work for you is easier.
You can also buy ETFs in the open market whereas, with mutual funds, you typically have to seek out the fund family and buy directly from them.
But with mutual funds, most fund families allow automatic investing, which is where you set up an investment program that takes a certain amount out of your checking account on a regular basis.
But be careful. Many mutual funds require a certain amount of money to invest — like $2,500.
However, sometimes that minimum can be waived if you are investing through a retirement account, like a Roth IRA.
ETFs are more tax-efficient and tend to be more liquid than mutual funds, which is good if you are buying and holding over the long term.
A downfall to an ETF is that it tracks a particular index. If that index is down, so is the ETF. If your ETF tracks the S&P 500 and the index sheds 20% of its value, the ETF will follow suit. There are also inverse ETFs that work counter to the index they track.
Because is it more actively managed, a mutual fund can enter and exit out of companies faster and isn’t tied to an index, so there is more flexibility in terms of holdings. That also means that if your mutual fund manager is more active, you have a stronger likelihood of outperforming an index.
Conclusion: Mutual Funds vs. ETFs
Ultimately, the decision of whether to invest in mutual funds or ETFs comes down to preference and investment style.
Both give investors diversification and the potential for long-term gains. Both pay out profits — which are subject to taxes.
An actively traded mutual fund can produce strong profits as securities are moved in and out of the fund more frequently.
With an ETF, if the index it tracks is doing well, so is the ETF.
But, again, you have to decide which strategy you are more comfortable with. Do you want to handle the buying and selling of securities yourself, or is it easier to have someone do it for you?
When looking at mutual funds vs. ETFs, like with any other kind of investing, do your research. Check the performance of the potential investment and what companies or other securities it holds.
Both can provide you with long-term profits. As always, just make sure you know exactly what you’re getting into first.