You probably know that you should diversify your investments. You don’t want all of your money in one stock – just ask anyone who owned a ton of Enron stock. An easy way to diversify without having to spend hours researching individual stocks is to purchase a mutual fund or exchange traded fund (ETF). Either one can be a good option, but there are some important differences you should understand. Let’s look at mutual funds vs ETFs.
Mutual Fund Definition
A mutual fund is a basket of stocks, that have been chosen by a fund management team. The team evaluates individual investments and they come up with a mixture they believe will offer a good return to investors. There are different types of mutual funds. Some funds have a goal of providing income to their investors so they invest in bonds (fixed income). Other fund focus on investing in stocks, some focus on large companies (large cap) while others focus on smaller companies (small cap) or international stocks.
ETFs typically track a specific index, like the Dow Jones or S&P 500. When you buy a share of an ETF you are buying a share of a portfolio that is built to match the specific index. ETFs are typically not trying to beat the index (often called “the market”). They are only looking to match the return of that index. Most ETFs are passively managed – they only sell items in their portfolio if the index they are following changes. For example, if a company is dropped from the S&P 500 and another is added the ETF will do the same. There are actively managed ETFs, but the majority are still passive funds that just seek to match an index and it’s performance.
A big difference between mutual funds vs ETFs is the way they are traded. Mutual funds only change their price once a day, after the market closes. When you place an order to buy or sell shares in a mutual fund your trade won’t happen until after the markets have closed and the price has been calculated for the day.
ETFs trade like stock in that they can be bought and sold while the markets are open. Their price changes based on how much investors are willing to pay for their shares. If someone is an active trader who wants to make changes frequently an ETF may be a more attractive option.
Fees are where ETFs really shine. Because mutual funds have a team they pay to research which stocks or bonds to purchase they typically have higher fees. They also often charge commissions when you buy or sell (load funds definition). The ongoing fees you pay for a mutual fund, outside of the commissions, are typically around 1+%.
ETFs don’t need a large team since they are simply following an index. They don’t charge commissions for these funds, although you do pay the costs of the trade. You will pay a fee annually for ETFs, but it is significantly lower than a mutual fund fee on average.
Mutual funds have recognized that they are losing significant amounts of money to ETFs due in large part to their higher fees. As such many funds offer no-load (ie no commission) funds. Many have lowered their ongoing fees as well.
Throughout the year mutual funds buy and sell stocks based on the recommendations of the fund managers. At the end of the year the fund must look at their capital gains (any stock that was sold for a profit) and their capital losses (any position that was sold at a loss). If the gains are more than the losses those must be paid to the investor.
While getting money from these funds sounds great, it is not ideal if you are investing outside of your retirement accounts. Retirement accounts like a 401(k) or IRA don’t require you to pay taxes until you withdraw your money. You will have to pay taxes on these mutual fund distributions if you are investing in a taxable account. This is painful because the majority of the time you are just taking the distribution and reinvesting the money, but you still have to pay taxes on those distributions.
ETFs on the other hand are not required to distribute their gains. They also don’t generate as many gains, since the holdings are not actively traded. They only change if the index it follows changes. You only pay taxes on the gains in an ETF when you sell an actual share of your ETF.
This is the area where mutual funds shine. If you want to buy $10,000 worth of an ETF that is easy – just buy the ETF and pay the trading fee for your purchase, $10 let’s say. On the other hand if you want to invest $1000 per month in an ETF you are going to have to pay that trading fee each and every time. In our example that would be $100 in trading fees which quickly eats away at the low fee advantage of an ETF.
Mutual funds on the other hand often allow for automatic investments. They let you purchase additional shares of a fund you already own without paying a trading fee. You need to make sure that you are purchasing a fund with this feature. Many brokers will allow you to make automatic investments for no fee, but only if it is their fund. For example if you broker at Fidelity you can automatically invest in Fidelity mutual funds for no fee, but other non-Fidelity funds would generate a trading fee.
Some brokerage firms have added this functionality to their ETFs. It is worth asking if they have no transaction cost ETFs you can invest in regularly.
Because ETFs trade just like shares of stock the minimum amount you can invest is simply the cost of one share. Mutual funds often have a minimum invest amount. Sometimes it is very low, but it can be quite high. Be sure to understand the minimums of mutual funds you are interested in purchasing.
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