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Mutual funds and Exchange-traded funds (ETFs) are both good options for investors, but it's important to understand the differences between these two similar investment options. My goal is to explain the pros and cons of each, and then you can decide which is better for you. (Of course, your decision may also depend on what account you are making the investment in.)
Exchange-traded funds (ETFs) have been around since the 1990s, but they have become more popular over the last few years. In fact, the number of ETFs grew from 102 in 2001 to 1,375 by mid-July 2014. ETFs are now found in many company retirement plans, and they're giving traditional mutual funds some healthy competition. While a fairly new option, ETFs are gaining popularity for their low costs and better tax benefits (especially when held in taxable brokerage accounts).
Still, most company sponsored retirement accounts still use just mutual funds - and these funds do have their advantages as well.
What Are Mutual Funds?
Mutual funds are made up of a pool of different shares of individual bonds and stocks that are specifically picked by a fund manager or management team. The price of a mutual fund is set at the end of every trading day so its price will not vary during the day. Mutual funds can be bought and sold at the end of the day once the price for the day is set based on the value of the individual fund investments.
Mutual funds have many expenses: commissions; operational costs; and redemption fees. Redemption fees are designed to discourage turnover, and you will need to pay the fee if the fund shares are sold within a specific period of time.
Mutual fund expenses may range from 0.1% to 3% per year. While you won't see these expenses highly advertised, they will impact your return.
Of course, some mutual funds like Vanguard and Fidelity Spartan funds are known for offering funds with low expense ratios and minimal fees.
Types of Mutual Funds
Mutual funds can be open-ended or closed-ended.
Closed-end mutual funds only issue a specific number of shares. No new shares will be issued as demand grows. The price of the mutual fund is not based on the net asset value of the fund, but investor demand.
Open-ended mutual funds account for most funds on the market. With this type, sales and purchases of shares occur between investors and the fund company. There is no limit to the number of shares that can be issued. The per-share price of the fund is based on the portfolio value, not the number of outstanding fund shares.
Open-ended mutual funds are usually just called "mutual funds" and closed-end mutual funds are called CEFs.
Indexed or Actively Managed
Mutual funds can also be indexed or actively managed.
Index mutual funds have portfolios designed to track or match components of a market index like the NASDAQ or S&P 00. These passive funds have lower expenses than managed mutual funds with broad market exposure and low turnover. The goal of an index fund is tracking the performance of an index as closely as possible. These funds are usually more tax efficient than managed funds, and they have lower expenses.
Actively managed mutual funds attempt to outperform indexes. Fund managers use market forecasting, research, and experience in an attempt to beat the market, although this isn't a guarantee.
What Are ETFs?
Like a standard mutual fund, an ETF holds a portfolio of securities made up of bonds or stocks. The main difference between the two is how you can buy and sell shares. When you buy into a conventional (open-ended) mutual fund, you buy shares from the fund company and sell them back to the fund shop. ETF shares, on the other hand, are bought and sold from other investors in the market, just like stocks. You will need to use a broker to buy and sell ETF shares.
ETFs are priced and traded on an exchange like the NASDAQ throughout the day, just like regular stocks, unlike mutual funds, which have a price set once at the end of the day. You can treat ETF shares like stocks with the ability to set market and limit orders or buy on margin. This means ETFs have greater trading flexibility.
How ETFs and Mutual Funds Compare
Here's how ETFs and mutual funds compare in a few important areas.
Taxes on Capital Gains
The IRS treats mutual funds and ETFs the same as both are subject to taxed dividends and capital gains taxes. Holding ETFs in a taxable account usually comes with fewer tax liabilities than mutual funds, however, because ETFs are structured in a way that minimizes taxes for the ETF holder.
Owning mutual funds means giving up control over when you take losses and gains.
So, unfortunately, mutual funds are one of the most tax inefficient investment options as it all depends on the decisions of the fund manager. A fund manager may, for example, sell some winning investors to stop losses and advertise a better return.
A fund managers constantly rebalance their fund by selling securities to accommodate redemptions and re-allocate assets. In mutual funds (but not ETFs) this creates capital gains for shareholders, even those who have an unrealized loss. And these can be both short-term and long-term gains.
This is harmful in two ways. Any short-term capital gains are taxed at your top marginal rate. And the tax creates a drag on your ability to compound your investment gains over time.
ETF managers, on the other hand, accommodate by creating and redeeming creation units, or baskets of assets that approximate the entirety of the ETF. This means investors aren't usually exposed to capital gains on any individual security.
Now you will have capital gains taxes on your gains for both ETFs and mutual funds when you sell your position from a taxable account. However, you can structure this to be at your convenience, and so that all your gains are long-term.
ETF and mutual fund dividends are treated in a similar way: dividends are taxed based on how long an investor owned the ETF fund. If it was held for more than 60 days before the dividend was issued, it's considered a "qualified dividend" and taxed at 0-20%. If the dividend was held for less than 60 days, it's taxed at the investor's usual income tax rate.
A big downside to mutual funds is most have a minimum investment amount, usually requiring at least $10,000 to begin investing. This can limit your ability to spread risk among many options. An ETF has no minimum investment.
Beause ETFs are priced continuously throughout the day on the open market, there is the potential to trade at a price that isn't the ETF's net asset value. ETFs also offer greater flexibility because they are traded like stocks: ETFs can be sold short, bought on margin, and sold with market or limit orders.
A mutual fund portfolio comes with an average of 2.5% in fees in the form of annual expenses and sales charges, although these fees can top 8.5%. Sales charges or loads are the broker's sales commission and they're deducted from your investment when you buy the fund. Annual expenses may include management fees, service fees, operating costs, and administrative fees.
In comparison, ETFs tend to be less costly because they have no sales commissions, which are usually between 1.0% and 1.5%. ETFs have an average expense of 0.44%.
One advantage of mutual funds here though is that you can trade them without commissions (which are charged every time you buy and sell an ETF). If you invest directly with a mutual fund like Vanguard or Fidelity, you can make your purchases without any commissions. This has great advantages in terms of lowering your cost if you make several purchases during the course of the year. And explain why many people prefer to hold mutual funds in tax advantaged accounts, but not necessarily in taxable accounts.
The Bottom Line
If you're considering two very similar investment options -- such as a mutual fund and ETF that both track the S&P 500 index -- it's important to consider other factors like taxes, the expense ratio, and commissions.
Investors who want to diversify will usually do better with ETFs as mutual funds are not as transparent and your portfolio may suffer from overlap, or holding several mutual funds that have many of the same stocks, which can overexpose your portfolio to individual companies.
ETFs also tend to work best for investors who are just starting out as they have lower costs and no minimum investment amount.