Every new investor faces many confusing choices in the financial market. This includes going national or global, selecting the right industries and sectors, and looking for growth or value in the shares. Another choice that often confuses the investor is the debate of ETF vs. mutual fund. Choosing between an exchange-traded fund or a mutual fund may not seem a big deal compared to all the other factors in the financial markets. But there are some major differences between the kinds of funds that can impact how much the investor makes in the financial markets and how they may make it. Both ETFs and mutual funds have portfolios of bonds or stocks and sometimes something a little more unusual, such as commodities or precious metals.
The funds must comply with equivalent rules regarding ownership, what amount can be pooled on a single holding, and more. Apart from these elements, the paths become different. A few of the differences may look a little out of the ordinary. But they settle the debate of ETF vs. mutual fund for you as an investor.
As the name goes, exchange-traded funds are traded on financial exchanges, just like the usual shares. The retail investor, not the fund manager, stands at the other side of this trade. The investor can sell and purchase the fund when the markets are in session, not just after the trading session has finished. They can get it at whatever the cost is at the given moment, depending on the conditions in the financial markets. There is also no minimum holding period for this instrument. This is a very crucial aspect when the fund is tracking global assets. Here, the cost of the asset has not yet been upgraded to show the latest info, but the market valuation of the country has factored it in. Consequently, the funds can show the latest reality of the financial markets faster than what the mutual funds can give.
Another major differentiator is that most of these funds track the index. This means they seek to match a specific index's price movement and returns, such as the S&P 500. They assemble a portfolio that matches the constituents of the index as closely as required. Passive management of the funds is not the only reason they are cheaper than mutual funds. The ETFs that track the index have lower costs than their equivalent mutual funds that track the index. The few ETFs that are actively managed are also cheaper than the actively-managed mutual funds. So, some other factors are involved in the ETF vs. mutual fund costs. It pertains to operating both the types of funds and the relationship between the shareholders and the funds. When an ETF is present, sellers and buyers are doing business with each other directly. So, the fund managers do not have a lot to do.
But the ETF providers want the cost of the ETF, which is set by the number of trades within a single day, to align as nearly as required to the net asset value of the underlying index. The funds adjust the supply of shares by redeeming old shares or developing new shares to perform this. If the cost is too high, the providers of the ETF will develop more supplies or try to bring them down. Everything can be executed with the help of a computer program, and no manual intervention will be required. The structure of the ETF results in greater efficiency in taxation also. The investors in the mutual funds and ETFs are taxed on a yearly basis based on the losses and profits that happen in the portfolios. But ETFs do not have much internal trading. So, this creates fewer taxable events. Such a fund's redemption and creation method decrease the need for selling.
Thus, unless an investor invests through any tax secured instruments such as their retirement funds, the mutual funds will give the taxable profits to the investor. This will happen even if the investor only holds the shares with them. Whereas, in a portfolio that only contains an ETF, the tax will usually be an issue only when the investor sells the shares. ETFs are quite new to the financial markets, while mutual funds have been around for a long time. So, an investor who has been around for some time is probably holding mutual funds with taxable gains. When they sell the mutual funds, they may incur taxes on capital gains. Thus, it is vital to include the cost of this tax in the decision to go to an index fund. The whole decision comes down to comparing the long-term advantages of going over to a better investment and paying more tax or staying in the current portfolio of not-so-perfect investments with higher expenses. The latter option may also cause a drain on the time of the investor.
When the investor puts his money in a mutual fund, the whole transaction is with the firm that manages it. The transaction happens through a brokerage company or directly with the fund managers. The buying of a mutual fund is done at the fund's net asset value. This is based on the cost when the financial markets close for the day. It can also be the next day if the investor places the order after the market closes. When the investor sells the shares, the same process happens again. But this time, it is the reverse. But the investor should not be in too much of a hurry. Several mutual funds have a penalty for selling too early, usually sooner than three months after the purchase of the funds. This can be about a single percentage point of the value of the shares. Mutual funds can track the indexes also. But several of the funds are managed actively. In such a case, the individuals who operate the funds can choose from a wide variety of holding to attempt to defeat the index that they judge the performance against. This can get quite costly.
The actively managed funds must spend their cash on tours to the organization, research, experts, and so on. That usually makes the mutual funds costlier to operate and for investors to have ownership of in the long term. Both ETFs and mutual funds are open-ended. This usually means that the number of shares that are outstanding can be adjusted down or up in reply to the demand and supply in the financial markets. When there is more money coming into and going out of a mutual fund on any particular day of trading in the financial markets, the fund managers will have to decrease the imbalance by making the extra money work in the financial markets. If they get a net outflow, they will sell off some of the holdings in case of a shortage of spare cash in the portfolio.
The debate between ETF vs. mutual funds can go on between experienced and new investors alike. You will have to choose which one would suit you given the gaps between both. Both the funds can serve specific requirements. Mutual funds are better for investing in shares that are not completely mainstream. This includes shares of smaller foreign firms and complicated yet rewarding sections such as market neutral, long, or short equity funds with lopsided risk and reward profiles. But in many situations and for many investors who would like to keep things quite simple, ETFs may have the advantage. This is because they place importance on index tracking, have ease of access, and have overall low costs. They have the capability to give exposure to several segments in the market in a simple manner that makes them great tools. That is if the investor's priority is to get long-term wealth with a broad and balanced portfolio.