Investors are known to have a love-hate relationship with (Extended-Trade Fund) ETFs and mutual funds. Many investors are afraid to invest in either because they’re unsure which is the better option for their money. This fear has led to some strange beliefs about the pros and cons of investing in each financial instrument. Regardless of your expertise as an investor, figuring out what form of investment is best for you can be challenging at times.
However, when it comes to mutual funds vs. ETFs, the pros and cons of each option must be considered before reaching a final selection. While both investments may seem similar on the surface, once you get past that point, several crucial differences between them that matter significantly when determining which is best for you and your money.
Investors pool their money into a mutual fund, which invests it in stocks, bonds, and other financial instruments. Financial advisors decide how much each form of investment should make up in a mutual fund's portfolio. Mutual fund managers select the securities the fund will buy and sell. The process of purchasing and selling shares of a mutual fund is known as “open-ended.” This means the fund does not have a fixed number of outstanding shares like most companies.
Instead, mutual fund companies issue new shares when investors purchase their funds. These investors then receive the total number of fund shares they paid for. When the fund company buys these shares, it does so at the current share price. Suppose the share price has fallen since the investor initially purchased the shares. In that case, the fund company will receive those shares at a lower price than the investor originally paid. Therefore, the fund company will have to make a difference when it sells these shares to other investors.
In an ETF or exchange-traded fund, various assets, such as stocks, bonds, commodities, and other assets, are pooled together. Like all mutual funds, ETFs are open-ended and are bought and sold on a stock exchange during the trading day. Investors purchase shares in the ETF, and those shares are traded just like shares of a company during the trading day.
A person who invests in the ETF owns a small piece of the fund managed by a professional fund manager. Because ETFs are traded like stocks and don't require a broker, they often have cheaper costs than mutual funds (like mutual funds do). ETFs also provide extra advantages over mutual funds. The most significant benefit of ETFs is that they are managed passively.
It means that the fund manager doesn’t try to “time the market” and buy and sell assets based on what they think the market will do. Instead, the fund manager buys a basket of different assets and holds those assets until the investor decides to sell the ETF. This means that ETFs are less risky than actively managed mutual funds.
On the surface, mutual funds and ETFs appear to be very similar. Investors purchase shares in these funds and can diversify their portfolios, whereas investing in individual stocks can be very risky. Both mutual funds and ETFs are a type of fund that allows investors to diversify their portfolios. They also offer instant diversification since you can buy and sell them anytime during trading.
While these two financial instruments are similar, there are a few key differences that investors need to be aware of. For one thing, Mutual funds often have higher expense ratios than ETFs, which can lower your return. Mutual funds have a team of people who actively manage the fund and incur significant expenses. These expenses are ultimately taken from the returns of the fund. ETFs have much lower expenses thanks to the passive approach. The lower expenses of ETFs can eventually lead to a higher return.
Investing in a mutual fund gives you a piece of a larger pool of money. You won’t have control over how the fund is invested. Mutual funds may be highly risky if they are heavily concentrated on a particular asset. ETFs are more diversified.
Investing in mutual funds as opposed to ETFs has a few advantages. A lower cost is associated with investing in mutual funds because they charge management fees that are built into the fund’s price. On the other hand, ETFs charge a commission when you purchase them, as stocks and bonds do.
There is also the risk of investing in ETFs that you won’t be able to get your money out when you need it. Mutual funds are held by brokerage firms and can be withdrawn at any time. You may not be able to sell your ETF at the proper moment in the case of a financial emergency or the need to access your money immediately.
Moreover, because they are traded on a stock exchange, they may have much higher transaction costs than mutual funds. These expenses vary widely depending on the exchange, but they can be up to 3.5 times higher than mutual funds.
An advantage of investing in ETFs is that they are passively managed which means there is less risk than with actively managed mutual funds. ETFs also offer instant diversification with a single purchase. You can buy one ETF and be instantly diversified among various assets. Unlike mutual funds, you don’t have to purchase many different funds to diversify your portfolio.
In addition, ETFs can be purchased and sold at any time throughout the trading day because they are exchanged on a stock market. You can buy and sell exchange-traded funds whenever the market is open, usually between 9:30 am and 4:00 pm EST. Some providers will even let you buy and sell ETFs outside these hours if there’s enough trading volume. Remember that trading costs will add up over time, so try to buy and sell ETFs at times of low trading volume to minimize these costs.
One of the most significant disadvantages of investing in mutual funds is that you don’t know what assets the manager has invested your money in. You can’t simply look at your portfolio and know what percentage of your money is in each asset class. This makes it more difficult to ensure that your portfolio is adequately diversified. Another disadvantage of mutual funds is that it’s difficult to determine the fund’s performance.
Mutual fund values are calculated based on the net asset (NAV). This value fluctuates throughout the day as mutual fund shares are bought and sold. Mutual funds do not have a fixed number of shares like stocks. The number of shares purchased during any given time period determines the value of the mutual fund.
Mutual funds also don’t have a fixed price like stocks. When you purchase a mutual fund, you can choose to reinvest your dividends or take them as cash. If you reinvest the dividends, the value of the mutual fund will decrease. When you sell a mutual fund, the value will increase. Mutual funds are priced based on the current value of their holdings.
Investing in ETFs has the major drawback of not providing immediate diversification. You can buy several mutual funds at the same time and be instantly diversified. You can’t do this with ETFs because you have to buy a variety of them to diversify your portfolio.
In order to properly diversify your portfolio, it may take a while. Another disadvantage of ETFs is that you don’t know what assets the manager has invested your money in. You can’t simply look at your portfolio and know what percentage of your money is in each asset class. This makes it more difficult to ensure that your portfolio is adequately diversified.
Mutual funds and ETFs offer investors the ability to diversify their portfolios in a single investment. There might be some parallels between the two financial vehicles; however, investors should re-think the positives and negatives of each before arriving at a decision. For one thing, ETFs are passively managed, whereas mutual funds are actively managed. Mutual fund managers constantly buy and sell assets based on their market outlook, which can be risky. On the other hand, ETFs simply buy a basket of assets and hold onto them. It can greatly reduce the risk to the fund.
Stockprices.com is a one-stop solution for all your investing problems. We believe investors should be aware of a number of the major distinctions between these two financial vehicles to make the best investment decision.