Exchange Traded Funds (ETFs) vs. Mutual Funds
Main Street Advisors, LLC
Exchange traded funds (ETFs) and mutual funds are two types of investments investors can use in their portfolio to grow their wealth and prepare for retirement. Both represent managed pools of individual securities such as stocks or bonds. They both provide exposure to a wide variety of asset classes and specific markets and can be used to create a diversified portfolio when funds from different asset classes are combined. So what is the difference between ETFs vs Mutual Funds?
What is an exchange traded fund (ETF)?
An ETF is a pool of securities that you can buy or sell through a brokerage firm on a stock exchange. ETFs are available through every asset class from traditional investments to commodities and currencies. They can help investors avoid short-term capital gains taxes, short markets and gain leverage. ETFs are bought and sold when the stock exchanges are open. They have a ticker symbol like that of a stock, but the number of shares outstanding of an ETF can change daily because of the continuous creation of new shares and the redemption of existing shares.
Pros of ETFs
- ETFs are easy to trade as you can buy and sell them at any point during the day.
- Tax efficiency, as they generate a low level of capital gains distributions.
- They are transparent because their holdings must be published daily.
- Lower costs. Most ETFs are passively managed and track a benchmark index, portfolio managers don’t actively manage the fund to try to beat the market or an index.
Cons of ETFs
- ETF sales are not settled for 2 days following a transaction; that means as the seller, your funds from an ETF sale aren’t technically available to reinvest for 2 days.
- Tracking errors can occur. The performance of the ETF may not precisely match the performance of the underlying index due to various factors, such as the fund’s expenses or the timing of when it buys and sells assets.
- Short-term trading costs. The commission costs of trading ETFs can add up over time, which can detract from investment returns.
What is a mutual fund?
A mutual fund is a company that pools money from many investors and invests the money in securities such as stocks, bonds, and short-term debt. The combined holdings of the mutual fund are referred to as its portfolio. When you buy shares in a mutual fund, you’re investing in many companies and market sectors at once. By purchasing a mutual fund, you own a piece of the fund’s overall portfolio. A mutual fund can earn dividends and interest from its holdings. The fund manager may opt to reinvest the profits or distribute them to investors. Mutual funds can generate losses as well. For example, if many investors decide to sell the fund at the same time. A mutual funds’ net asset value (NAV) is calculated at the end of each trading session at the market’s close. Mutual funds are professionally managed with their own strategy and management style, depending on the fund. They also charge fees to the investor such as expense ratios. Some funds also charge load fees, which is a form of sales charge or commission.
Pros of mutual funds
- Favorable returns.
- They are convenient. You can hold them in various types of accounts, including employer-sponsored retirement accounts, an individual retirement account (IRA) or in a brokerage account.
- Many have low fees (expense ratios), and there are even some without expense ratios (low-cost mutual funds are typically passively managed rather than actively managed).
- Strong diversification. They invest in many companies, greatly reducing investor risk.
Professional management. There are two types of management styles: passive and active. Index funds are an example of a passive investment strategy. The fund tracks a specific index, such as the S&P 500. An active investment strategy uses investment analysts to try to find stocks that will outperform a benchmark index.
Cons of mutual funds
- Some mutual funds carry high fees.
- Tax consequences. Sometimes year-end distributions arise when a mutual fund sells securities from its portfolio. These distributions are taxable investment income for the investor and are taxed at either ordinary income rates or capital gains rates, depending
- on how long the fund held an investment, which could possibly mean a higher-than-expected tax bill at the end of the year.
- No intraday trading. Mutual funds are traded only once per day after the market closes at 4 p.m. Eastern time.
What are the primary differences between ETFs and mutual funds?
| ETF | Mutual Fund | |
|---|---|---|
| Tax efficiency | Have lower turnover and can use the in-kind creation/redemption process to manage the cost basis of their holdings, so they have fewer capital gains. | The sale of securities within a mutual fund may trigger capital gains for shareholders. |
| Trading | Trade like stocks and are bought and sold on a stock exchange. Prices fluctuate throughout the day. | Orders are executed once per day, so all investors on a given day will receive the same price. |
| Costs | ETFs are traded directly on an exchange and may be subject to brokerage commissions, which can vary depending on the firm. They also charge expense ratios, although they are typically lower than mutual funds. These management fees are the main costs investors pay with this type of fund. These fees compensate the fund manager for expenses related to administering the fund. Two other factors that will impact the cost of the ETF are the bid-ask spread and the market price and NAV. | Can be purchased without trading commissions, but in addition to operating expenses they may carry other fees such as sales loads or early redemption fees |
| Management | They can be passively or actively managed. Most are passive investments pegged to the performance of a particular index. | They can be active or indexed, but most are actively managed by fund managers. |
| Minimum Investment | Do not require a minimum initial investment and are purchased as whole shares. | Minimum initial investments are normally a flat dollar amount and aren’t based on the fund’s share price. Can be purchased in fractional shares or fixed dollar amounts |
| Transparency | Daily disclosure of holdings. | Quarterly disclosure of holdings. |
| Minimum investment | Smaller investment so ideal for those with limited disposable income (retail investors) | Lump-sum investment is permitted |
| Structure | Less Complex | Complex |
Both investment instruments can add value to portfolios. The investor’s individual needs and preferences such as investment objectives, time horizon, risk tolerance, diversification, liquidity needs, tax situation and overall goals will drive the decision-making process. Speaking with an investment fiduciary can help you determine the best mix based on your individual circumstances.
Please contact us at (410) 840-9200 with any questions.
Main Street Advisors, LLC April 2023. Main Street Advisors, Inc. is a Registered Investment Advisor. The articles and opinions expressed in this material were gathered from a variety of sources, but are reviewed by Main Street Advisors, LLC, prior to its dissemination. All sources are believed to be reliable but do not constitute specific investment advice. The views expressed are those of the firm as of April 2023 and are subject to change. These opinions are not intended to be a forecast of future events, a guarantee of results, or investment advice. Any advice given is general in nature and investors must consider their own individual situation. Always contact your financial/investment professional before making any financial decisions. Main Street Advisors, LLC is not responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results.
Sources:
Schwab. (2023). ETFs vs. Mutual Funds
https://www.schwab.com/etfs/mutual-funds-vs-etfs
Forbes. (October 2022). What is a Mutual Fund?
https://www.forbes.com/advisor/investing/what-are-mutual-funds/
Fidelity. (2023). ETFs 101
https://www.fidelity.com/learning-center/investment-products/etf/what-are-etfs
NerdWallet. (February 2023). ETF vs. Mutual Fund: What’s the Difference?
https://www.nerdwallet.com/article/investing/etfs-vs-mutual-funds
