Whether you’re starting your investment journey or looking to learn something new, in this article we’re breaking down the differences between an exchange-traded fund (ETF) and a mutual fund.
When trying to decide which investment strategy is right for you, it can be difficult to choose between ETFs and mutual funds. Both have their advantages and disadvantages, so it pays to do your research before making a decision.
Exchange traded funds are baskets of securities that trade on exchanges like stocks. A mutual fund is a professionally managed investment portfolio that pools investors’ money together in order to purchase a variety of assets such as stocks, bonds, and real estate investments.
In this article, we will explore the differences between these two types of investments, including the costs associated with each option and how they may fit into your overall investing strategy. By understanding the similarities and differences between both options you can make an informed decision about which one is right for you.
The basics: ETF vs mutual fund
ETFs, as the name might imply, are funds that are traded on an exchange, a basket of investments like stocks or bonds. These can track a particular sector, index, commodity, or other assets, with the first ETF tracking the entire S&P 500, the SPDR S&P 500 ETF (SPY). By investing in the S&P 500 ETF, one is investing in all 500 stocks that make up that particular index.
An actively managed mutual fund on the other hand is a pool of funds managed by a team of professionals and might include a mix of stocks, money market accounts, bonds, and other options. Unlike ETFs, these actively managed funds can only be traded once a day after the markets have closed as their prices are set once a day.
ETFs and mutual funds: the similarities
While they differ in significant ways, these two investment instruments also have some similarities.
1. Both mutual funds and ETFs are managed by professionals
Both ETFs and mutual funds are managed by professionals that are responsible for which investments go into the funds. The difference here is how they're managed. ETFs are passively managed funds while the latter is an actively managed fund.
2. Both carry less risk than single stocks
Exchange-traded funds, much like a mutual fund, offer investors the ability to pool their resources and invest in a variety of businesses. Mutual funds and ETFs are inherently less risky than investing in single stocks due to the diversification they provide. However, these two forms of financial investments have distinct goals that set them apart (which we will discuss shortly).
3. Both offer a wide range of investment opportunities
Both mutual funds and ETFs offer a wide variety of options when it comes to investing. From a fund that reflects the stock market to one filled with a combination of stocks and bonds to one that follows a particular industry such as technology, there is more than likely to be an ETF or mutual fund out there covering just what you're looking for.
ETFs and mutual funds: the differences
An important component of understanding these two instruments and determining which one is right for you is establishing the differences between the two. Below we take a look at the differences between a mutual fund and an ETF.
1. They function differently
While ETFs mimic the market producing returns based on the index they follow, a mutual fund is a collection of investments designed to outperform the market. Mutual funds are created by teams looking to build an attractive investment, while ETFs are more typically a collection of "like-minded" investments.
2. They're managed differently
As touched on above, ETFs are passively managed while a mutual fund is actively managed. Let's break that down. ETFs simply follow the market index for which they're created, and can typically offer lower fees due to not needing a team of managers to select the investments.
Mutual funds on the other hand are actively managed by professionals and designed to beat average market returns making them susceptible to higher fees (and higher returns). A mutual fund is the best solution for diversifying risk.
3. They're bought differently
ETFs are traded on stock exchanges in the same way that stocks are, allowing investors immediate trading access during stock exchange hours. These instruments can be bought and sold for particular prices at particular times of the day. Some might say that ETFs are essentially mutual funds that can be traded like stocks.
Mutual funds however can only be traded after market trading hours and have their price set once a day. To buy actively managed mutual funds, one will need to use a financial advisor, a broker or purchase directly from the fund itself. One might also be able to buy mutual funds from a mutual fund company directly. This instrument also allows for automatic monthly payments providing an easier solution to consistent investing.
Which is right for you: ETFs vs mutual funds
While neither mutual funds nor ETFs is perfect, both ETFs and mutual funds are great options for investing. Mutual funds tend to be more highly recommended for retirement and other long-term saving goals while ETFs are almost always more tax efficient due to the nature in which they are traded. Which is the right instrument for you will be determined by your needs and preferences.
Best long-term investment option: mutual funds
To build a secure retirement nest egg, it is essential to make wise investments for the long run. Mutual funds are an ideal option as they provide great returns and stability over time, allowing you to leave them for 10, 15, or even 20 years.
Best short-term investment option: ETFs
Investors are able to capitalize on ETFs just like stocks, actively trading them during the day in an attempt to realize short-term gains and make quick returns. While mutual funds are known to be more expensive options, ETFs tend not to be entirely fee-free either. It's important to note that these come with costs each time that you invest, incorporating operating costs, transaction costs, or could be in a fee-based account.
Conclusion
ETFs are designed to mimic market indexes and have been shown to provide 10%-12% growth over longer periods of time.
Mutual funds on the other hand are designed to beat market averages, providing higher returns over the long run. Investors looking for a diversified long-term option are advised to look at these four growth stock mutual funds: growth, growth and income, aggressive growth, and international. Always look to mutual funds that have proven results in terms of long-term growth.
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