Investing in funds, either mutual funds or exchange-traded funds (ETFs), is a great way to easily obtain diversified investments. Funds enable investors to skip the tedious task of researching individual companies and creating their own diversified investment portfolios.
Most investors don’t have the time or expertise to create a diversified investment portfolio of individual stocks and bonds. That’s where funds come in. Yet, with thousands of funds from which to choose, it’s easy to become overwhelmed or even paralyzed by the choices.
The Similarities of ETFs and Mutual Funds
Both ETFs and mutual funds own many stocks, bonds or both. And both types of funds are categorized by style and type. For instance, you can buy an S&P 500 index mutual fund like Schwab S&P 500 Index Fund (NASDAQ: SWPPX) that owns most of the stocks, in the same proportion, as the S&P 500 index. SWPPX has a low, 0.03% expense ratio.
Or you can achieve the same investment goal with an S&P 500 index ETF like SPDR S&P 500 ETF (NYSE:SPY), which has a .09 % expense ratio. Like Schwab’s S&P mutual fund, SPY seeks to provide investment returns that match those of the S&P.
All of the S&P 500 funds will own the stocks in the S&P 500 index. You know some of the names; Apple (NASDAQ:AAPL) Facebook (NASDAQ:FB), Kraft Heinz (NASDAQ: KHC), Proctor and Gamble Co (NYSE:PG) and PepsiCo, Inc. (NASDAQ:PEP).
ETFs and mutual funds could be passively managed funds, i.e. they seek to emulate the performance of indexes or they could be actively managed by professionals. But mutual funds are more likely to be actively managed than ETFs.
Both ETFs and mutual funds are less risky than buying an individual stock or bond. Since each fund has tens to thousands of individual stocks or bonds, if one stock or bond in a fund is underperforming, there’s a good chance that other ones it owns are doing well, offsetting the losses of the underperformer.
ETFs and mutual funds can be purchased through your investment broker or the mutual fund issuer. But the way you purchase each is different.
The Differences Between ETFs and Mutual Funds
ETFs and mutual funds trade in different ways. You can buy and sell an ETF throughout the day on the financial markets, just like an individual stock. That gives you more control over the price you pay for it. In most cases, you’ll have to pay a trading commission, although some investment firms don’t charge commissions for ETF trades.
Mutual funds are priced once per day, at the end of the day. All mutual funds are sold by their issuer (Vanguard sells Vanguard mutual funds and T. Rowe Price sells its brand of mutual funds), and you usually don’t have to pay a transaction fee to buy them.
You can also buy mutual funds through “supermarkets” such as a discount broker like Schwab or E*TRADE (NASDAQ:ETFC). You might pay a transaction fee if you buy a fund through a supermarket. Also, you could buy a mutual fund from an investment broker, but you should check the broker’s fees before doing so.
If you’re buying a mutual fund through the 401(k) provided by your employer, you usually don’t have to pay a transaction fee.
Which Is Better?
As with most investment questions, the answer is, “it depends.” If you’re regularly increasing the amount of money you invest and you have to pay commissions on ETF trades, then you’re better off buying a mutual fund.
In general, most ETFs charge lower management expense ratios than mutual funds.
If you’re a trader and want to capture small price movements in the fund, then an ETF is for you. Speculators and sophisticated investors may want to take advantage of the fact that ETFs can be shorted.
If your employer only offers mutual funds, then the choice has been made for you.
If you’re short on cash, ETFs typically require lower minimum investment amounts. Many, although not all, mutual funds have $1,000 to $3,000 initial minimum investment amounts. Conversely, you might be able to buy a share of two of an ETF for a much lower amount of money.
ETFs typically disclose their holdings daily, making it easy to see which stocks and/or bonds you own. Actively managed mutual funds only reveal their investments quarterly or semi-annually.
Generally, ETFs are more tax-efficient than mutual funds. The capital gains and dividends of ETFs and mutual funds are taxed the same. But ETFs have fewer taxable events than mutual funds. When a mutual fund’s shares are redeemed, the fund might need to sell shares, creating a taxable event. Since shares of an ETF are bought and sold among investors, the underlying stocks or bonds don’t need to be sold as frequently, limiting the number of taxable events.
If you want to leave the decision of whether to buy an ETF or mutual fund up to the pros, you might prefer to let a robo-advisor choose for you. This choice allows you to obtain a professionally managed portfolio without any of the hassle.
The Best Way to Choose Between an ETF And a Mutual Fund Is…
Figure out what type of fund you’re seeking; a stock index fund, a blended fund with stocks and bonds, a bond fund, an actively managed fund or a target-date retirement fund.
Then compare the fees and holdings of similar ETFs and mutual funds.
Most major investment brokers have ETF and mutual-fund screeners. You input your criteria, and the screener provides a list of funds for you to evaluate.
In the end, both mutual funds and ETFs have their advantages and disadvantages. Simply identify your investing goals and select the type of fund that works best for you.
Barbara A. Friedberg, MBA, MS is a veteran portfolio manager, expert investor, and former university finance instructor. She is editor/author of Personal Finance; An Encyclopedia of Modern Money Management and two additional money books. She is CEO of Robo-Advisor Pros.com, a robo-advisor review and information website. Additionally, Friedberg is publisher of the well-regarded investment website Barbara Friedberg Personal Finance.com. Follow her on twitter @barbfriedberg and @roboadvisorpros. As of this writing, she does not hold a position in any of the aforementioned securities.