Mutual Funds vs. Exchange-Traded Funds
July 17, 2020
Mutual funds and exchange-traded funds (ETFs) have many similarities. Both allow investors to own a diversified “basket” of securities like stocks or bonds. Both are managed by experts and can be set up as index funds or actively managed funds. Both have an expense ratio, and both are less risky than investing in individual stocks or bonds. Despite all these similarities, there are differences between ETFs and mutual funds, and choosing which one is best for you can depend on your goals and needs.
What Is a Mutual Fund?
A mutual fund is an investment vehicle designed with a specific objective in mind. They are funded by shareholders and managed by a professional fund manager. When selecting a mutual fund, your primary concern should be whether the fund’s objective aligns with your investment objective. Are you looking to track an index or have an actively managed fund with a better chance of outperforming a benchmark index?
Once a share of a mutual fund is purchased, your money is pooled with that of all the other investors of the fund. The fund manager will then select investments that will help the fund achieve its objectives. Because the fund manager is so essential to the success of a mutual fund, it is also a good idea to do some research into the manager’s experience with the fund or similar funds.
What Is an Exchange-Traded Fund?
An exchange-traded fund is an investment vehicle designed to provide a diverse portfolio of securities with a single purchase. As the name implies, ETFs are also traded on an exchange much like stocks. Exchange-traded funds fall into the same two major categories as mutual funds — index funds and actively managed funds. However, there are far fewer actively managed ETFs than mutual funds.
Benefits of Exchange-Traded Funds
One of the main benefits of ETFs is that they cost less than mutual funds on average. The expense ratio, the cost paid to the fund management company, is typically much lower in an ETF than an equivalent mutual fund. ETFs are also more tax-efficient than mutual funds. Many mutual funds will distribute capital gains annually, creating taxable income for shareholders even if you hold your shares. With ETFs, most taxable gains are only realized upon selling your shares. ETFs have also become commission-free, with most brokerage firms eliminating the normal trading cost in 2019.
In addition to costing less, ETFs have other benefits such as their transparency, ease of trading, and customizable investments. On the transparency front, when you purchase an ETF, you know exactly what you are buying. By going to the ETF provider’s website, you can see everything that makes up your investment. With mutual funds, you will generally only be able to see the top 10 holdings within the fund.
EFTs are easier to trade than mutual funds because they can be traded throughout the day (mutual funds are traded at the end of the day). This means that you have more flexibility when buying or selling an ETF, giving you the ability to react to changing market conditions. They also give you the choice of investing in more specific parts of financial markets, including stock sectors, commodities, and foreign countries among others.
When are Mutual Funds Better Options?
In certain cases, a mutual fund may be a better option than an ETF. If you want active management or a balanced fund with both stocks and bonds, have a small amount of money to invest, or are investing in a company-sponsored retirement plan, mutual funds may be the better choice.
As we have already mentioned, while it is possible to have an actively managed ETF, there are many more actively managed mutual funds. If active management is something you are seeking, then mutual funds may give you a wider variety of investments to choose from. However, you should keep in mind that choosing active management will also come with an increase in cost in the form of a higher expense ratio. So make sure you fully research the fund manager and their long term historical performance.
Another scenario in which a mutual fund may be the preferred option is when you are interested in balanced funds that include both stocks and bonds. These types of funds are also known as hybrid funds. Examples of hybrid funds include growth & income funds, balanced mutual funds, and target-date mutual funds.
If you only have a small amount of money to invest, mutual funds can allow you to make the most of what you have. Unlike ETFs, mutual funds allow for fractional investments. Rather than only being able to purchase entire shares, you can purchase a fraction of a share for a fraction of the price. Imagine that you have $100 to invest and there is a mutual fund and an ETF that both have shares worth $30. If you select the ETF, you will be able to buy 3 shares and have $10 left uninvested. But if you select the mutual fund, you will be able to buy 3 and ⅓ shares and invest all of your money.
Finally, company-sponsored retirement plans, such as 401(k)s, usually offer mutual funds to the participants. If you’re investing in one of these plans, then you are likely to be investing in a mutual fund rather than an ETF.
Mutual funds and ETFs have both similarities and differences. While each has pros and cons, we generally recommend ETFs because of their lower cost, transparency, and ease of trading. Both mutual funds and ETFs give you the ability to invest in a diversified portfolio of securities, so choosing what is best for you depends on your personal goals and needs.
Trinity Wealth Management
If you wish to learn more about mutual and exchange-traded funds, please contact our team today. Our fiduciary financial advisors can help you determine which type of investment is right for achieving your goals.
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