Are you an investor looking to expand your portfolio but aren’t sure of the right option for you? Now is the perfect time to look into funds — but how do you choose between mutual funds and exchange-traded funds (ETFs)? While mutual funds and ETFs have plenty in common, there are a few key differences between those two that can make one option better than the other.
What Are Exchange-Traded Funds?
Exchange-traded funds or ETFs are investments that pool money from investors to use the funds to purchase bonds, stocks, or other securities. Investors are welcome to buy and sell shares of ETFs much like you would with shares from a stock exchange. As such, it works similarly to how you would buy shares from the New York Stock Exchange, which is why it’s called an exchange-traded fund.
However, to make use of an ETF, an investor will need to pay a fee to the company which is paid as a percentage of the assets or an expense ratio. This fee can be relatively low if the fund manager’s job is simple in a heavily traded broad market index fund. The expense ratio is much higher in actively managed funds where investors are paying for allocation management and research.
What is a Mutual Fund?
Mutual funds also pool money from investors to purchase bonds, stocks, and other securities. However, these investors will purchase mutual fund shares directly from the company that issues the shares, such as Fidelity or Vanguard. Mutual funds will often be more actively managed compared to an ETF, but you may also purchase mutual funds which track the market index.
The expense ratios for a mutual fund are often identical to that of an ETF, but the index funds will generally be lower compared to an actively managed mutual fund. Because you need to purchase and hold a share of the mutual fund from the company that provides it, you won’t be able to move your assets. Unless you sell them, which will enable you to place them in another financial institution.
What’s the Difference Between Them?
As mentioned, there are key areas in which the two funds differ — these are in the aspects of management, fees, and trading abilities.
In general, a mutual fund will be run by a professional manager who will attempt to beat the market by selling and buying stocks while relying on their expertise. This is what we call “active management” which will often cost more for investors.
On the other hand, ETFs are typically managed passively. These will often track a pre-selected index automatically, such as the Nasdaq 100 or the S&P 500. There are, however, some actively managed ETFs that work much like mutual funds, and will therefore have higher fees.
ETFs will usually track an index, so their expense ratios will often be very low. For instance, Vanguard has a 0.03% expense ratio on their S&P 500 ETF. This cost can make a huge difference when it comes to long-term investors.
Another thing to consider is the fact that ETFs are traded during an exchange — this means you can buy and sell them all day. There’s no minimum amount required, and investors who are new to funds can get started by adding just one share of an ETF to their retirement account.
As mentioned previously, ETFs will usually track an index, but these funds come with a great advantage. These are traded all day like stocks, so their prices are based on demand and supply. Mutual funds, on the other hand, are priced and traded at the end of every trading day.
This kind of trading structure found on ETFs also means that whenever you buy and sell, you may need to pay for commission. The good news is, this practice is becoming more and more uncommon since many major brokerages are eliminating commissions on stock, ETF, and options trades. While this is great news if you want to buy ETFs, remember that many brokers will still need you to hold on to an ETF for several days or you will be charged with a fee.
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