What's the Difference Between Mutual Funds and ETFs?
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. 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?
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
Mutual Funds — have a lock-in period which ranges from 3 months to 5 years
ETFs — have no lock-in period
Liquidity
Mutual Funds — lower liquidity due to lock-in periods and end-of-day sales
ETFs — higher liquidity with market price sales any time during the day
Mutual Funds — 1.05% to 2.25%
ETFs — 0.03% to 1%
Transaction Costs
Mutual Funds — often include "front-loaded" or "back-end" transaction costs and brokerage fees
ETFs — usually no transaction fees for U.S.-based ETFs
Price to Purchase
Mutual Funds — price calculated at end-of-day net asset value
ETFs — price based on current market value
Why do people use them?
The greatest appeal of mutual funds is that professional fund managers actively manage them. This can be a good strategy for DIY investors who prefer not to deal with the details. However, it also results in higher fees for clients and less flexibility for investment managers.
Which does NEST use and why?
We use ETFs at NEST. Here’s why:
We manage our own investments using a macro-view of the economy — we can’t guarantee mutual fund managers do the same
We rely on our own data sources, not financial media
We avoid extra mutual fund fees in favor of our clients
We value nimbleness and need to be able to act quickly based on what our data tells us
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.
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.
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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.