ETFs vs. Mutual Funds: Which One is Right for You?

Image Source: SBNRI

Mutual funds and ETFs both have perks for your investment mix, like easy diversification at a low cost. But they differ, especially in cost. Generally, ETFs come out ahead because they usually use passive investing and have some tax perks. Here's the lowdown on what sets mutual funds apart from ETFs and which might suit your portfolio better.

Mutual Funds or ETFs: Safety & Other Factors

Both mutual funds and ETFs aim to do similar things, so the best long-term pick depends on what the fund invests in (like types of stocks and bonds). For example, mutual funds and ETFs based on the S&P 500 index will perform pretty much the same. However, actively managed funds can have very different outcomes based on their investments. The differences really show up in fees, commissions, and other costs. Here, ETFs usually have an advantage over mutual funds. They also tend to be more tax-efficient, which can lower your overall tax hit.

When it comes to safety, neither mutual funds nor ETFs or stocks are inherently safer due to their structure. Safety depends on what the fund owns. Stocks are generally riskier than bonds, and corporate bonds are a bit riskier than U.S. government bonds. But higher risk (especially if diversified) might mean higher long-term returns. So, it's crucial to understand your investments' details, not just whether it's an ETF or mutual fund. A mutual fund or ETF tracking the same index will give about the same returns, so risk exposure is similar.

ETFs for First-Time & Young Investors

Image Source: YouTube

ETFs can be a solid choice for first-time investors of any age. Most ETFs pool investor money to buy individual securities, mirroring an index. The returns will be close to the index or other indicator. ETFs are professionally managed and traded throughout the day on exchanges. They don't need a minimum investment because they trade as shares. There's a huge variety, including ETFs tracking major indexes and specialized indexes for sectors, industries, and regions. The biggest ETF is the S&P 500 (SPY) Index.

For young investors with a long-term, buy-and-hold strategy, mutual funds can be a smart move. They've been around for years and have proven themselves as solid investments. They offer instant diversification, professional management, and both passive and actively managed options. You don't have to buy individual stocks, bonds, or other assets yourself. Plus, they're affordable, with many not requiring a minimum investment.

Distributions by Mutual Funds and ETFs

Image Source: The Motley Fool

Mutual funds might pay capital gains distributions at year-end and dividends throughout the year, while ETFs might pay dividends throughout the year. But there's a difference in these payouts, and ETFs have an edge here, too. ETFs might pay a cash dividend quarterly. Each share gets a set amount, so more shares mean a higher payout. However, not all funds offer dividends, even if they do provide a cash payout. For example, fixed-income ETFs technically pay out interest instead. ETF distributions can be either qualified or non-qualified. The difference depends on how they are taxed and how long the stock within the ETF is held:

• Non-qualified dividends are taxed at the usual income rates.
• Qualified dividends are paid on the shares that are held by the ETF for more than 60 days during a 121-day period starting 60 days before the ex-dividend date. These are taxed at the capital gains rate.

Mutual funds might also issue a payout, possibly regularly throughout the year. Investors might also benefit from rules on qualified dividends for a lower tax rate on payouts. But mutual funds can bring an extra tax hassle. They must distribute their realized capital gains at year-end. While you get the payout in cash, you might have to pay taxes on it to the IRS. These tax issues don't apply to mutual funds in tax-advantaged accounts. Even if the mutual fund isn't trading a lot of stocks, redeeming shares for outgoing investors can force managers to sell shares, potentially creating a capital gain.

Plus, if you buy the fund late in the year, you could end up paying a tax bill for events that happened before you invested.

You May Also Like: The Pros & Cons Of Exchange-Traded Funds (ETFs) Investments

Best Time to Purchase ETFs and Mutual Funds

The time and frequency for buying mutual funds and ETFs aren't the same. Mutual funds get priced only at the end of each trading day, so even if you place an order anytime, it won't be filled until the day-end price is calculated. You won't know the exact price until the transaction is done, but you'll always pay the exact net asset value. On the other hand, ETFs trade like stocks on an exchange, so you can buy them whenever the market is open. You can place buy or sell orders just like with stocks and see the exact price when the order goes through. Unlike mutual funds, you might pay a bit more or less than the net asset value, but the difference is usually tiny. This flexibility has made ETFs a popular investment choice.

Mandatory Purchases & Commissions Involved

When it comes to commissions, ETF investors have it pretty good. Big-name brokerages have cut commissions to zero for all ETFs on their sites, so trading these funds is free, though some brokers might charge an early redemption fee. This is great, especially if you like to dollar-cost average your purchases. Mutual funds, though, might still charge sales commissions, sometimes one or two percent of your money, or even more. Luckily, many mutual funds don't charge these fees anymore, and it's easy to avoid them. Otherwise, you'd be paying the fund-management firm at the expense of your returns. Brokerages might also charge fees for trading mutual funds, up to $50 per trade, but the best brokers offer many funds without trading commissions.

As for minimum purchases, ETFs usually have an edge. A broker might require you to buy at least one share, but many now allow fractional shares. Even if you need to buy a full share, it could cost as little as $20 up to $250, which is relatively small. Some mutual funds, however, might require at least $2,500 to start, with smaller subsequent deposits, and might charge early redemption fees if you sell within 30 days.

Expenses and Expected Returns

The active vs. passive debate shows passive investing does better most of the time. A report from S&P Dow Jones Indices found that 93% of U.S. active managers in large companies couldn't beat the market over a 20-year period ending Dec. 31, 2023. While the best funds can beat their benchmarks in a given year, it's tough for active managers to outperform over time. Passive investing aims to match the market, not beat it, and if it outperforms most investors, it means you can beat the most active professional managers. This advantage leans toward ETFs, which are usually passively managed, though some mutual funds are too. You'll need to check the fund's prospectus to know for sure. Active management also tends to cost more than passive funds. The rise of lower-cost ETFs has helped reduce mutual fund expenses. Expense ratios on funds have been dropping over the past two decades, but stock mutual funds still cost more than ETFs, whether you look at a simple average or an asset-weighted average.

A few years ago, an average mutual fund would cost 0.44% of your assets each year, while an average ETF cost just 0.16%. But if you focus on passively managed stock mutual funds, they're actually cheaper than passively managed stock ETFs. In the same period, stock index mutual funds charged an average of 0.05%, while comparable stock index ETFs charged 0.16%. Active mutual funds might also increase your tax bill by recognizing capital gains more frequently and passing on taxable gains to investors at year-end. Plus, mutual fund investors might have to watch out for sales commissions, which can eat into your principal before you invest. ETFs and the best mutual funds don't have this issue. Whether you choose an ETF or mutual fund, check the expense ratio and other costs. Costs significantly impact your return, so focus on those first, especially for index funds where everyone tracks the same index.

Similar Reads You May Enjoy: ETP Vs. ETF Explained: Decoding The Major Differences

Passive or Active Management

How a fund invests plays a big role in your costs and potential returns. Some funds use active management, where the manager picks and chooses what securities to buy and sell, and when. This is more common with mutual funds. The other way is passive investing, where the manager doesn't pick the investments but follows an index like the S&P 500. This is more common with ETFs, though sometimes ETFs are actively managed too. So usually, mutual funds are actively managed, and ETFs are passive. But these days, you can find actively managed ETFs and passively managed mutual funds.

This difference is important because it affects the returns you might get and the expense ratio you'll pay.

Conclusion

ETFs are often a better choice for investors because they offer tax advantages, low commissions, and easy trading. But for some situations, like stock index funds, mutual funds can be cheaper than ETFs, especially in tax-advantaged accounts. Either way, understand what your funds are invested in and how they help you reach your financial goals.

This content was created by AI