Mutual funds and ETFs are two ways investors can diversify their assets. While there is some overlap in their behavior, they have fundamental differences. Let’s explore what mutual funds and ETFs are and how they differ.
A quick note: for the purposes of this article, we’re talking about no-load mutual funds, also known as index mutual funds. We’ll get into the different types of load mutual funds in a future post.
What are Mutual Funds?
A mutual fund is a professionally managed investment fund that trades in diversified holdings. Basically, they pool money from various investors and use those funds to invest in things like stocks and bonds. This combination of holdings is their “portfolio.”
People who invest in mutual funds do so by buying a share. This share represents their part ownership in the fund.
What are ETFs?
ETF stands for “exchange traded fund.” Like a mutual fund, an ETF is an investment vehicle that pools money from investors and uses those funds to buy baskets of stocks, bonds and securities. Investors can buy or sell shares of an ETF just like they could shares of stock from a stock exchange. ETFs operate similar to mutual funds in many ways, though there are key differences.
ETFs often track a particular sector, like tech or energy, an index, or a commodity, similar to mutual funds. Unlike mutual funds, investors can purchase or sell ETFs on a stock exchange like a regular stock. ETFs were introduced in 1993 to track the S&P 500 and were required by law to be primarily passively managed until 2008. Although there are some actively managed ETFs, they are still predominantly passive. Investors who desire exposure to a specific sector while maintaining diversification, liquidity, flexibility, and fee minimization often favor ETFs.
How are Mutual Funds and ETFs similar?
In the way they’re constructed, ETFs and mutual funds have a lot of similarities. So similar, in fact, that some investors don’t understand the difference.
Here’s some commonalities:
- Both collections of shares of many different stocks or bonds are grouped together and traded as one unit.
- They often mimic benchmark indices like the S&P 500 or the Dow Jones.
- They allow investors to diversify their portfolios by letting them easily invest in a range of businesses and asset classes, depending on the fund.
- They minimize trading transaction costs because of their size, through large lot share transactions.
- They can be risky or conservative, depending on the investments that comprise the portfolio.
What are their primary differences?
How they’re traded
- Mutual Funds — traded at Net Asset Value which is calculated at the end of the day
- ETFs — traded at the current market value, like stocks, which fluctuate all day
How they’re purchased
- Mutual Funds — only invested in through an intermediary like a fund manager, which means more fees
- ETFs — purchased directly from the stock market with no intermediary
Managing the funds
- Mutual Funds — the fund manager decides how your money is managed
- ETFs — you or your investment manager decide how your money is managed
Lock-in periods — a period during which you can’t sell shares without a fee
- Mutual Funds — have a lock-in period which ranges from 3 months to 5 years
- ETFs — have no lock-in period – this allows flexibility to be responsive to changing economic conditions
Liquidity
- Mutual Funds — lower liquidity because they sell at the end of the day, they have lock-in periods, and often have back-end fees
- ETFs — higher liquidity because you can sell at market price instantaneously throughout the day, have no lock-in periods, and no management fees
Expense Ratio — what percentage of a fund’s assets are used for administrative and operating expenses
- Mutual Funds –- expense ratio of 1.05% to 2.25%
- ETFs — expense ratio of 0.03% to 1%
Transaction Costs
- Mutual Funds — there are often transaction costs such as “front-loaded” or “back-end” plus additional brokerage fees
- ETFs — usually no transaction fees for ETFs if they are US based
Price to purchase
- Mutual Funds — purchased at a price that is calculated once a day, at the end of the day, for a price based on their net asset value
- ETFs — purchased in a stock exchange, and the price is based on whatever investors are willing to pay at the time
Why do people use them?
The greatest appeal of mutual funds is that professional fund managers actively manage them. Investors rely on the management decisions of these professionals to build an optimal portfolio for their goals, rather than just following an index. This can be a good strategy for DIY investors who find the world of investing confusing and prefer not to treat their money like a game. However, investment managers view it as another form of laziness, as it means they don’t have to strategize or keep a close eye on this aspect of their clients’ portfolios. It also results in higher fees for clients, including the fee paid to the investment manager and the fee paid to the mutual fund manager.
Which does NEST use and why?
When we weigh the benefits and drawbacks of both mutual funds and ETFs, ETFs win by a long shot. So, if the answer wasn’t clear by now, at NEST we use ETFs.
Why? Several reasons:
- We manage our own investments using a macro-view of the economy — we can’t guarantee that mutual fund managers use the same strategy
- We are particular about where we get our data, and we make financial decisions according to our own analysis of raw data
- We want to charge our clients for our services only, not adding on the additional fees incurred with a mutual fund
- We value being nimble to economic changes, and having the flexibility and liquidity to buy and sell shares according to what the data says at a moment’s notice aligns with that.
If you have more questions about ETFs or mutual funds, and why at NEST we prefer one over the other, feel free to reach out to us. Educating clients, both current and future, is at the core of who we are at NEST. We want to give you the tools and professional guidance to help you make the best financial decisions for you, your family, and your future.
At NEST, we have nearly 30 years experience serving the greater Austin and Hill Country areas. We are passionate about helping individuals, families, business-owners and entrepreneurs reach their financial goals. Are you ready to partner with a team that will have your back and won’t steer you wrong? Why not schedule a no-obligation call with us?
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DISCLAIMER:
This article provides educational information and opinions only and does not constitute financial planning or investment advice.
For guidance about your unique goals, drop us a line at info@nestfinancial.net.
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