Most individuals are familiar with mutual funds, but we find many people are not as familiar with, or have never heard of, ETFs. Today we’ll cover the differences between these two investment vehicles. While this isn’t a complete guide to mutual funds and ETFs, we hope by the end of this you will have a better understanding of these investment options and why one may be the better choice over the other.
In essence, mutual funds and exchange-traded funds (ETFs) are two types of funds consisting of a mix of many different assets (stocks, bonds, etc…) and represent a common way for investors to diversify their portfolio.
Mutual funds typically come with a higher minimum investment requirement than ETFs. Those minimums can vary depending on the type of fund and company. For example, an investor may need a minimum of $3,000 to invest into a single mutual fund. This is going to be dependent on the mutual fund manager and the specific requirements for their mutual funds.
Many mutual funds are actively managed by a fund manager or team making decisions to buy and sell stocks or other securities within that fund in order to beat the market and help their investors profit. With that being said, this often leads to higher expenses within the mutual funds in comparison to ETFs. ETFs are mostly passively managed, as they typically track a specific market index; they can be bought and sold like stocks. Because they are more passively managed, this is how ETFs are able to keep their internal expenses lower than traditional mutual funds.
Most mutual funds are open-ended mutual funds. With open-ended funds, the purchase and sale of fund shares take place directly between investors and the fund company. There’s no limit to the number of shares the fund can issue. So, as more investors buy into the fund, more shares are issued. Purchases and sales of mutual funds take place directly between investors and the fund. The price of the fund is not determined until the end of the business day when net asset value (NAV) is determined. ETFs are more liquid than mutual funds in that they trade intraday much like a stock.
Lastly, ETFs offer tax advantages to investors. As passively managed portfolios, ETFs (and index funds) tend to realize fewer capital gains than actively managed mutual funds.
For example, suppose an investor redeems $50,000 from a traditional Standard & Poor’s 500 Index (S&P 500) fund (mutual fund). To pay the investor, the fund must sell $50,000 worth of stock. If appreciated stocks are sold to free up the cash for the investor, the fund captures that capital gain, which is distributed to shareholders before year-end. As a result, shareholders pay the taxes for the turnover within the fund. If an ETF shareholder wishes to redeem $50,000, the ETF doesn’t sell any stock in the portfolio. Instead, it offers shareholders “in-kind redemptions,” which limit the possibility of paying capital gains.
While these are only some of the differences between mutual funds and ETFs, we hope this cleared up some confusion with these two investment options. In the end, if you’re looking for more active management within your investments, a mutual fund may be the way to go. But, if you’re looking for a passive, cheaper, more tax efficient way to invest then an ETF may be a better fit for your goals.
Ben Webster, CFP® and Derek Prusa, CFA, CFP®
Co-Founders and Owners of Aspire Wealth
July 2021 Newsletter
