When you look at your investment portfolio, you may find a few things: mutual funds, exchange traded fund (ETFs) and quite a few others. If you’re deeply involved in retirement planning, you probably know the difference between a mutual fund vs. an ETF.
However, many people don’t know the key differences between these two, nor do they worry about it – especially if these accounts make good returns.
We’re going to walk you through the concept of a mutual fund and an ETF, how they differ and when each is beneficial.
ETF vs. Mutual Fund: Understanding the Basics
ETFs and mutual funds are different, and they each have different structures. Before we go into the main differences, it’s crucial to define mutual fund and ETF.
What is a Mutual Fund?
A mutual fund is a way to diversify an investment portfolio. For example, there was a time when people trying to secure their retirement would invest in IBM, Google, energy stocks and so on, but they were required to purchase each stock separately.
Mutual funds have a purpose, such as mimicking the S&P 500, specific sectors and so on.
The purpose is what makes up the entire fund. As an investor, if you want to mimic the S&P 500 and invest in a mutual fund to do this, you can be confident that the fund will include a mix of all stocks in the index. Additionally, you don’t have to manage each stock individually.
One mutual fund can include 50 to 1,000 individual stocks to make investing more efficient because the diversification is already done for you.
Think of a mutual fund as a company that has a stockbroker who works behind the scenes to manage diversification.
When you own mutual funds, the one thing to know is that when you sell a share in a mutual fund, it’s not done until the end of the day. So, you may put in a sell order at 9 am, but the sale doesn’t happen until 4 pm when the markets close.
If the market goes or up or down during this time, you’ll be impacted as a result.
What is an ETF?
An ETF is similar in nature to a mutual fund, and while they’re vastly popular, they only came about in 1992. Due to their efficiency, ETFs are an excellent option. When selling an ETF, the structure allows you to sell in the same way as an individual stock.
You can sell an ETF at any time of the day.
So, if you’re invested in a technology ETF, you benefit from the entire industry without the risk exposure of investing in just one stock. The price movement of the ETF is live, so you can sell at any time to recognize the real-time price.
Buying and Selling Mutual Funds vs. ETFs
We looked at the buying and selling of mutual funds and ETFs, but let’s look at a clear example of the two because it can be quite confusing. Let’s run through a scenario of buying and selling a mutual fund first:
- It’s 10 am in the morning and the mutual fund is $100
- You put in a buy or sell for the mutual fund
- The buy or sale doesn’t go through until the market closes at 4 pm
- At 4 pm, the mutual fund is valued at $80 a share
If you were buying in the above scenario, you would benefit from the lower share price at the close of the market. Sellers would see share value fall by 20%, losing out on significant profits.
ETFs offer the benefit of immediate sales. Here’s an example:
- It’s 12:30 pm and shares are up 25% on the day.
- You put in a sell order.
- The sale is immediate, and you sell at the high of the day.
Since ETFs are sold just like a stock, you can react to current market conditions, which is beneficial. You can also purchase ETFs in the same way.
Over time, there has been the evolution of ETFs turning into actively managed funds.
What is Active Management?
If we go back to our section on mutual funds, you’ll remember that mutual funds have a manager that works to keep a portfolio diverse. For example, let’s assume that the company’s technology mutual fund includes Apple because it’s one of the leading tech companies in the world.
If Apple stock started falling drastically on poor financials and key leadership leaving the company, active managers would sell the shares in Apple and adjust to market conditions.
Through active management, stocks enter and exit the fund to pad investors against losses and keep the fund profitable.
Actively managed ETFs work in this same way, yet you can sell the ETF immediately, too. The trading and efficiency of the ETF allow you to sell off the share while benefitting from active management.
Fees and Costs
Mutual funds are set up as a company, so you’ll find that they have fees and costs that are often more expensive than an ETF counterpart. You’re paying for the company’s financial experts to manage the fund in the best way possible to maximize returns.
However, fees and costs are often higher for the mutual fund because the company has a lot of overhead.
ETFs are more efficient, so the cost of maintenance is typically a little lower than a mutual fund. Brokerage fees are often not an issue if you invest in ETFs, but they can become expensive if you regularly invest small amounts of capital. Making larger investments less frequently may be the better option in this case.
However, the total fees for an ETF are often significantly less than a mutual fund.
We’re not saying that ETFs or mutual funds are better, but we use ETFs almost exclusively because they cost less and give you more control over your investments. We’re not saying that there aren’t great mutual funds out there, but they’re just not our preferred option.
ETFs offer the flexibility to sell or buy at any time while the market is open, and this is a freedom that mutual funds simply don’t offer.