Ep. 150 – What’s The Difference Between a Mutual Fund and an ETF?
Are you torn between investing in a mutual fund or an ETF?
Both mutual funds and exchange-traded funds (ETFs) are alike in many ways but also have a few differences. They both make investing very easy and represent diversification.
In this episode of the Secure Your Retirement podcast, we talk about the differences between a mutual fund and an ETF. Listen in to learn why ETFs are more efficient and low-cost as compared to mutual funds and are suitable for anyone looking to be actively managed.
In this episode, find out:
- Defining a mutual fund – a fund with a purpose that can represent multiple stocks.
- How a mutual fund operates on an “end of day pricing” during purchase and sale.
- How an ETF operates the same way as an individual stock and can be sold or bought at any moment of the day.
- The actively managed advantage that both mutual funds and ETFs offer.
- A mutual fund has a higher expense ratio compared to an ETF which is more efficiently managed.
- An ETF enables you to get in and out of the market without having to wait for the market to close.
- “A mutual fund is designed as a company that is there to make a profit, and so it’s going to have a manager, a team under the manager, and all the overhead that it takes to manage it.”– Murs Tariq
- “There’s no way to invest for free; you’re always going to have some fees in whatever investment you choose.”– Murs Tariq
- “If you’re trying to decide between a mutual fund and an ETF, it’s worthy to try to figure out how each works.”– Radon Stancil
If you are in or nearing retirement and you want to gain clarity on what questions you should be asking, learn what the biggest retirement myths are, and identify what you can do to achieve peace of mind for your retirement, get started today by requesting our complimentary video course, Four Steps to Secure Your Retirement!
To access the course, simply visit POMWealth.net/podcast.
Here’s the Full Transcript:
|Radon Stancil:||Welcome everyone to our Secure Your Retirement podcast. Today we are doing an episode what we reference and talk about, which is in Retirement in Action. And on these kind of episodes what we’re really trying to do is to identify areas and to talk about areas where people have questions and maybe they’re thinking about, “How do I invest and how do I structure my retirement investing plan to be able to take care of what I need to do as far as a return? But at the same time, what’s the best way or the way to reduce risk?” And all those kind of things.|
|So today’s topic is what’s the difference between a mutual fund and an exchange-traded fund known as an ETF? So maybe you’ve heard, maybe you’ve been listening to a TV program around investing and they talk about these things called ETFs, that stands for exchange-traded fund. And you might wonder, “What’s the difference between an ETF or a mutual fund or what is an ETF?”|
|So our goal today is to really go through the differences between the two so that you can understand how they’re structured, how they look, how they act. And so I’m just going to open it up here and Murs going to is really kind of operate this as if we’re having a discussion around this is, if we were sitting there talking to you at the table and you ask us, “What’s the difference between our mutual fund and an ETF?”|
|So I’ll just pose it to you, Murs. Why don’t we do this? In order to start this, why don’t we just say this? What is, in fact, a mutual fund? Let’s go that way and then that’ll help us draw the differences.|
|Murs Tariq:||Yeah, I think that’s a good place to start. And I think the best way to even understand why mutual funds and why ETFs are even around is if you go way back when investing first started, all your options really were to invest in directly into individual securities. So you would go invest in IBM directly. You’d go invest in Microsoft directly. You’d go buy all these different stocks and essentially a need became created of we need a better way to diversify without having to buy a hundred or a thousand different stocks all at once. And that’s just a lot of work to do.|
|And so I think that’s where the mutual fund arena came about. Mutual funds have been around for a very long time. And essentially what a mutual fund is is a company that has a purpose, a fund that has a purpose. So the purpose could be to mimic an index like the S&P 500 or the Dow Jones or the NASDAQ. Or their purpose could be to mimic a specific sector of the market like technology, like financials and all those different sectors out there.|
|And so once they have their purpose set up and this goes from mutual funds and ETFs, and we’ll get into that. But once you have your purpose set up as to what your fund is going to be, then you go and the mutual fund or the ETF is going to go and put all those various stocks that represent that purpose within their fund. So basically you’ve got a company, a mutual fund company that defines the purpose and then goes and buys all these different stocks that answers what that purpose is.|
|And so you get a very good diversification out of that because basically you buy one mutual fund and that one mutual fund could represent 50, 100, maybe up to a thousand different stocks all aligning with what that original purpose was. So the idea, the concept of a mutual fund and now the ETF I think it’s very strong. It makes investing by itself just way more efficient. Again, go back. If you wanted to have a well-diversified portfolio, you had to buy a bunch of stocks and that became back in the day that was a lot of commissions they had to deal with, a lot of trading they had to deal with and a lot of stocks that you had to manage.|
|Now you can fulfill that with just buying one or two different mutual funds that covered really as much as you want in the investing world. And then that evolved, that evolved significantly to different styles of mutual funds. Different actively managed, passively managed, index managed type of mutual funds and then came around basically what we’re talking about now is the ETF. So Radon and I, we were having a quick conversation before we recorded this. And I was like, “When did ETFs come around?” Because we all I’ve heard of mutual funds. It’s a very common term in the world of investing, but ETFs, we actually looked it up and they started in 1992.|
|And so here we sit in 2022, ETFs have really only been around for 20 years now, but they have gotten so much of a media presence. Everyone is talking about ETFs and why they work so well, how efficient they are. So that’s kind of why we wanted to have this whole conversation, a mutual fund versus ETF. Not to say that one is better than the other. They just operate a little differently. So that’s a little bit of a summary as to what a mutual fund is and we’ll get into some of the differences, but Radon, I’ll throw it back to you. Let’s talk about ETFs.|
|Radon Stancil:||Yeah. And so before I jump into the ETF, I do want to just bring up a couple of points on the mutual fund and just really, I guess, highlight that is that with a mutual fund I always explain it as a company. A mutual fund is a company and inside that company is a stockbroker and that stockbroker is going and buying different stocks. And the way it works is that let’s say that I this morning woke up and decided I did not want to be in this mutual fund anymore. And I decided to sell that mutual fund.|
|If I put the order in this morning at 10 o’clock and said, “Sell the mutual fund.” The way it’s structured is is that my sale of that mutual fund does not go through until the end of the market day. So if you live on the East Coast, that’s four o’clock. At four o’clock, that’s going to be when my mutual fund is sold. So the price that I get for that mutual fund is whatever all of those stocks equaled at the end of the day. So if I woke up that morning and let’s say that I was in a financials type mutual fund and the financials are really high and I said, “I want to capture those highs sell.”|
|But at the end of the day in the afternoon, those financials sold off, I don’t get the benefit of the morning. I get the demise of the afternoon because my price is the end of day pricing. So that’s what I wanted to use the segue over into the ETF and ETF is structured differently. An ETF instead of being this idea of I’ve got to have this value at the end of the day, it moves and operates just like an individual stock would.|
|So if I were looking at, let’s say IBM. I can look at IBM all day long and say it’s worth whatever it’s worth at that real point. And I could sell it at any point throughout the day and get the price of whatever IBM is throughout that day. An ETF operates in the very same way. And there are many thousands of different types of ETFs, but let’s just say that I wanted to go in and instead of just buying IBM, which is a technology-based company. If I said, “I don’t want to have the risk of IBM by itself. I want to go buy the technology companies.”|
|I can go buy a technology ETF that is many different technologically-driven companies. And I benefit from the whole industry, but I don’t have the risk exposure of just one. So I might have IBM. I might have Microsoft, Apple, all of the main companies, thousands or hundreds of companies within that ETF. But the beauty is is that the price movement of all of those stocks are live. So if I decide I wake up that day at 10 o’clock and all of the technology part of the world is doing well. I can say sell right now at this price. And I recognize the price immediately. I don’t have to wait till the end of the day.|
|By the way, go back to the buying side. Let’s say that I say on the mutual fund side, I wake up at 10 o’clock and I say I want to buy this mutual fund. And I put the order in to buy it, I don’t own it until the next day. I don’t get any benefit of that day. Whereas with an ETF, I can wake up at 10 o’clock and say I want to own it today and buy it right there at 10 o’clock. So I’m able to pick when I buy it and when I sell it.|
|So there’s lots of advantages. Now, the ETF world started out with this world of really being a passive type of a fund. So I bought technology. I bought the S&P 500. I buy the Dow Jones. And it just does whatever those indexes do, but there has been some evolution and some of the evolution in the ETF world are actively managed. So Murs, could you kind of help us appreciate what actively managed means, which does bring us kind of back to an idea of a mutual fund, but we still get the benefit of buying and selling immediately.|
|Murs Tariq:||Yeah. So go back to when you said a mutual fund has basically a manager that is within it and that manager has some type of, he used the word earlier, a definition that they have to achieve this goal of setting up this fund and let’s go with technology. So that mutual fund manager has to essentially do data through analytics, fundamentals, technicals, all those different things to make some decisions as to what the best technology stocks are that he or she is going to put into their mutual fund. And their role as a manager is to be actively moving that around, based off of the market.|
|So it could be that Apple. Apple has had a very good run. We have all heard of Apple. So Apple’s very likely is going to be in all technology mutual funds and all technology ETFs because it’s one of the largest technology companies in the world. But it could be that Apple has issues and that mutual fund manager decides for whatever reason to take that out of the fund. And that’s what’s being called actively managed based off of a rule set, based off of metrics that they use they’re going to switch things in and out, in and out of the fund on the mutual fund side.|
|On the ETF side, that’s the evolution that has come. It used to be like Radon said was passive that we just want to mimic an index. If we’re going to buy technology, let’s just go buy the largest cap-weighted technology stocks. The ones that have the most weight in the market, let’s just go buy those into the ETF and let’s just hold those. And then we’ve got good diversification. We’ve got exposure to hundreds of different technology companies, but then we also have now the evolution of that actively managed ETF, but still the efficiency is still there.|
|So you could have that manager in the ETF buying and selling based off of their rule set, based off of their metrics, saying, “Here’s who we think are the best technology companies in the world today and we’re going to put them in our fund knowing that very likely next month it’s not going to be the same fund. Next month is not going to be the same company or we’ll rotate some in and out based off of, again, some time at the rule set.”|
|But the big difference here is, again, the trading aspect of it, the efficiency of it. And that comes back into oftentimes you’ll hear of mutual funds having some fees in there, some more expenses in there, higher expense ratios. And if you think about it, a mutual fund is designed as a company that is really there to make a profit. And so a mutual fund is going to have not just the manager, but the team under the manager and all of that overhead that it takes to maintain this mutual fund, there’s expenses in there.|
|And if you compare that to the ETF, while there’s still expenses in the ETF, there’s no way to invest for free, really. You’re always going to have some fees in whatever investment you choose. The ETF has a very more efficient way of doing things. So typically your mutual fund is going to have a higher expense ratio because of some of the costs that goes into maintaining that, whereas ETF is going to be a little bit lower.|
|Radon, you mentioned and we’ve been talking about technology for some reason even though that’s had its ups and downs throughout the year, but technology we have been in and out of technology ETFs. So an example is XLK. XLK is a very well-known ETF. It’s a very large ETF, there are millions and billions of dollars in the ETF. And just to give you an example, go back to what you would have to do to mimic this. Some of the holdings in XLK are Apple, Microsoft, NVIDIA, Visa, MasterCard, Cisco, Adobe, Salesforce. So all these different companies already wrapped into this ETF, so you don’t have to go buy them on their own. So again, kind of talking to the efficiency of how an ETF can work.|
|So I think that there’s a lot to understand as to … And again, everyone has different strategies. Radon and I, we really like ETFs because of their efficiency and because of their low cost. We’re able to get in and out whenever we want to get in and out and not have to wait for the market to close, whereas that’s the mutual fund world. And so I think it really just depends on what type of strategy that you’re looking for. If you’re wanting to be truly actively managed, then the ETF really has the efficiencies for that and the maneuverability for that.|
|Radon Stancil:||Yeah, I think at the end of the day we’re not trying to say that mutual funds are bad and ETFs are great by themselves. But I think for what we choose and I think that’s what the whole world is based on is our choices and our options. And we choose to use exchange-traded funds almost exclusively. We don’t say we would never use a mutual fund, but it’s rare for us to ever own a mutual fund in the portfolio. But it’s basically what’s been developed that is actually better in our opinion in a lot of different ways that a mutual fund simply because it gives us a lot more flexibility.|
|But obviously, it’s something that if you are looking at them or you’re trying to make a decision between the two, it’s worthy of you trying to figure out, “Hey, how does an ETF work?” And that’s our goal in this particular ETF. By the way, if you would like to talk to us about how we do what we do, why we do what we do, we encourage you to reach out to us. Just go to our website, which is pomwealth.net. You can go to the top right corner. You got a button there that you can click that says complimentary phone conversation and you’ll see our schedule, you can book it right with us, and we encourage you to do that.|
|And Murs and I will hop on the phone and answer any questions that you’ve got whatsoever and completely no obligation, completely complimentary. So we encourage you to do that, but we thank you so much for listening. We’ll talk to you again next Monday.|