Differences and Considerations: ETFs vs Mutual Funds

This guide takes a deep dive into the ETF vs Mutual Fund debate.

We look at how the two assets compare, contrast and help you decide which one is better for your investment portfolio.

When it comes to investments, traders and investors are spoiled for choice. There are several avenues to deploy their cash to work for them, including stocks, bonds, bills, funds, forex, and commodities. This list excludes more exotic investment opportunities such as cryptocurrencies or more traditional venues such as real estate. Still, however you look at it, there are tons of options from which to choose.

Including mutual funds and exchange-traded funds (ETFs) within your investment portfolio is an excellent way to cut down on your decisions. Instead of choosing between two stocks within the same industry, funds provide you the opportunity to invest in an entire sector or an index that tracks the performance of stocks within the same industry.

ETFs and mutual funds both serve the same purpose: diversification. But which one should you select among the two fund categories? Which one is better for your portfolio and why? As discussed in this guide, ETFs and mutual funds have several similarities, but they also differ in more ways than one. It is hard to generalize comparisons between ETFs and mutual funds since both can be subdivided into smaller subcategories. These smaller units tend to overlap in terms of features, properties, advantages, and drawbacks.

Continue reading to find out if an ETF or a mutual fund is better for your investment portfolio.

1. Management

A mutual fund is a pool of investor resources used to purchase a basket of assets such as stocks, bonds, or commodities. Shares of the fund are sold directly to investors by the fund manager.

One major characteristic of mutual funds is that they are often actively managed by the fund managers who regularly rebalance the basket’s constituents to try and beat benchmark performance metrics. Because mutual funds are often actively managed, they tend to cost more in expense ratios and tax liabilities than their ETF counterparts.

2. Diversification

ETFs (exchange-traded funds), just like mutual funds, are pools of investor resources used to buy a basket of assets including stocks, bonds, commodities, or even exotic assets such as cryptocurrencies. However, unlike mutual funds whose shares are sold directly to investors by the fund managers, shares of ETFs are listed on public stock exchanges such as the NASDAQ or the NYSE. Investors can then buy, sell and exchange the ETF shares just as they would stocks during market trading hours, thus the name ‘exchange-traded fund.’

ETFs are often passively managed, which contributes to their lower management costs, and these typically track the performance of an index such as the S&P 500. However, ETFs are increasingly becoming more diverse as fund managers create more actively managed funds that mimic several aspects of mutual funds.

3. Pricing

At the creation stage, shares of both ETFs and mutual funds are priced by the investment companies that create them based on the net asset value (NAV) and the number of shares in each fund. After the creation, mutual funds are then priced every day at the close of the trading session by determining the NAV of the fund using the closing market prices of the assets within the basket.

Investors and traders cannot buy and sell shares of a mutual fund during regular trading hours, and any orders to purchase these shares are only fulfilled once the market closes. The fund manager thus determines the prices at the time of recalculation of the fund’s NAV.

4. Commissions, Taxes and Expense Ratios

On the contrary, ETF shares trade on the stock exchanges just like stocks giving investors and traders the chance to buy, sell and exchange the shares as often as they would like as long as the markets are open. It may seem like a great feature of the ETFs that demand and supply market forces determine their prices, but this can easily lead to over or undervaluation of the ETF shares compared to their NAV.

5. How to buy, minimum investments & redemption limits

The way you buy fund shares differs between ETFs and mutual funds. While you can make an order to purchase mutual fund shares at any time within the day, your order will not be filled until the end of the core trading session when the fund manager tallies up and determines the fund’s net asset value. You may end up paying more or less for your investment than initially intended.

6. Fund returns

When it comes to investment returns, it can be challenging to decide which investment is better than the next, and this is coupled with the fact that there are no guarantees in the business. A good investment today might not be in the future. Past performance does not necessarily represent future outcomes, but past performance can indicate what to expect in the future.

Conclusion

From our arguments in the previous section, you can conclude that both ETFs and Mutual funds have their advantages and drawbacks as investment vehicles. This section highlights these advantages more concisely for easier comparison, and we’ll start with the benefits of ETFs:

ETFs and mutual funds provide an excellent diversification tool for investors but, as we have highlighted in this guide, choosing which one is right for you may not be as easy as it looks. There are several factors to consider, and no one asset is necessarily better than the other. Your particular circumstances will dictate which works best and which one to avoid.

Disclaimer: The content on this site should not be considered investment advice. Investing is speculative. When investing, your capital is at risk.