When investors want to put money into the market, but they don’t want to pick and choose individual stocks and bonds, they often turn to investment funds to achieve their financial goals. Broadly speaking, investors in this scenario have two choices: exchange-traded funds (ETFs) or mutual funds.
Both of these investment products are similar. ETFs and Mutual funds are strategically grouped funds that contain a mix of securities that are designed to achieve a specific goal. When an investor buys a single share of a ETF or mutual fund, they’re essentially buying fractional positions in dozens (perhaps even hundreds) of individual securities. These securities may be stocks, bonds, derivatives, commodities. An investor can gain exposure to practically anything that’s publicly traded through a specialized ETF or mutual fund.
While mutual funds and ETFs may both work toward similar financial goals, they go about it in different ways. These differences seem subtle, but they can have significant impacts over time. Here’s what you need to know if you’re considering investing in ETFs or mutual funds.
What is a Mutual Fund?
Generally speaking, a mutual fund is simply when investors pool together their money to buy a group of securities that are jointly owned by everyone who contributed money. Let’s look under the hood to see how these funds actually work.
When people refer to “mutual funds,” they’re usually talking about an open-end investment fund. These are sometimes also referred to as an “open-end investment company”. These funds are entities that collect money from investors and use the cash to buy more securities. The pooled cash from investors is managed by a fund manager who decides when to buy and sell securities. The securities they buy depend on the goal of the fund. This often involves largely replicating an existing index of stocks or bonds, like the S&P 500.
An investor can buy more shares in the fund any day, aside from weekends and holidays. They can sell their shares back to the fund for cash. Investors may trade fund shares directly with the entity that manages the fund. Or they may trade shares through a brokerage firm.
A closed-end fund starts out in a similar manner as open-end funds. Investors buy shares directly from the investment company and the company pools together the cash to buy securities that track a set index.
The major difference with closed-end funds is that they function like an initial public offering (IPO). There’s a set timeframe when investors can participate in this initial process of contributing money to the fund. After the IPO period closes, the shares are then traded on exchanges, just like stocks and ETFs. When an investor buys a closed-end fund, they aren’t contributing money to the fund. They’re trading directly with another investor who owns a share in the fund and is willing to sell it. That means that the shares may not directly reflect the value of the fund’s holdings.
What is an ETF?
An ETF can be thought of as a mix of the two funds described above. It incorporates elements of both types of products to create a unique type of investment fund.
An ETF is like an open-ended mutual fund because investors who buy ETFs are essentially (though not literally) kicking in money that the fund manager uses to buy securities held by the fund. Buying an ETF gives your investment portfolio exposure to the fund’s holdings. Like the other funds described, these holdings often track an index.
An ETF is also like a closed-end fund because it trades on the public exchanges, just like stocks. They can be bought or sold at any point during the trading day. However, unlike with closed-end funds, there are procedures in place for keeping the ETF share price close to the net asset value (NAV) of the fund’s holdings.
How Are ETFs And Mutual Funds Created?
Both ETFs and mutual funds are created by major financial institutions. They both involve creating the fund’s basket of securities, which could include a mix of cash, stocks, bonds, and many other publicly-traded securities. These funds are managed by a fund manager. They aim to ensure that the fund fulfills its financial goals — whatever those goals may be.
Organization of ETFs
As mentioned above, investing in an ETF is kind of like kicking in money to buy into a basket of holdings. However, investors aren’t literally giving money to a fund manager who then buys securities proportionally. Instead, something known as the redemption and creation process keeps the ETF share values fairly close to the fund’s NAV. This process involves creating and destroying shares in large volumes to keep the share value close to the net asset value (NAV) of the fund holdings. Major financial institutions work with ETF managers to carry out this process. This process isn’t perfect, and the ETF share values may fluctuate above or below the NAV throughout the trading day, but the share values generally track fairly closely with the true NAV.
If any of the companies held by the ETF issue dividends, then those dividends will be disbursed among ETF investors in proportion to the number of shares they hold. The same goes for income from bonds held in a bond ETF.
Organization of Mutual Funds
With open-ended mutual funds (which covers most common mutual funds), an investor is essentially giving cash to the fund manager who buys more securities with the investor’s money. The fund manager may also sell securities. Any capital gains from those sales are distributed evenly to investors along with any dividends or interest payments from companies and bonds held by the fund.
Risk Tolerance: ETF vs Mutual Fund
Depending on your investment choices, ETFs and mutual funds both come with similar levels of risk. However, these risks are much different from the risks that come with investing in stocks. While stock risk is tied to a specific company, the risk levels of ETFs and mutual funds are tied to the bundle of securities that a fund manager chooses to include in the holdings. This generally translates to reduced risk. This is due to the benefits of diversification — but it depends on the specifics of the fund in question.
In other words, investors have a greater ability to control their risk exposure when they’re investing in ETFs and mutual funds, but there are relatively few differences between ETFs and mutual funds that track similar indexes. For example, a bond mutual fund that tracks an index tied to 20+ year Treasury securities will come with relatively low risk, as will an ETF that tracks that same index. On the other hand, ETFs and mutual funds that track small-cap growth companies will be both be relatively risky investments.
Returns: ETF vs Mutual Fund
The relationship between ETF returns and mutual fund returns is similar to their risk relationship. There are some key differences though. One major difference stems from the way taxes apply to the two products. ETFs are generally regarded as more tax-friendly. The idea behind that argument is that they give investors greater control over when the taxes will apply. ETF investors are taxed based on the capital gains of their position (when they choose to buy and sell). Mutual funds are taxed differently, in that all investors are taxed for every trade that the fund manager makes. This gives mutual fund investors less control over when they’re taxed. ETF investors can take advantage of timing strategies such as tax-loss harvesting.
ETFs are also more likely to be passively managed. Passive management involves picking an index, such as the S&P 500, and then simply replicating that index exactly. Since this strategy requires less work on the part of the fund manager, the ETF costs are lower. Mutual funds may be passively managed, but many are actively managed (as are some ETFs). Active management requires the manager to make more decisions about how to balance the fund’s holdings. As the level of decision-making increases, so do the costs that the manager charges to fund investors.
Those two cost differences threaten to eat into your overall returns. This is especially true when you’re investing on a long timeline (like in a retirement account). However, the returns based purely on the performance of the holdings are likely to be similar. This is as long as the ETFs and mutual funds being compared are tracking similar — if not identical — indexes.
How To Invest in Mutual Funds
The process of investing in a mutual fund is similar to investing in stocks or bonds. All an investor needs to do is open a trading account with a financial institution. Whether it’s by a trading app on your phone or a decades-old investment bank you visit in-person. Once you’ve opened a brokerage or retirement account, you can research mutual funds and place orders to buy or sell shares in them. Stocks and bonds, which trade on open markets throughout the day. Mutual fund orders commonly execute at one set time every day however. This is usually done after stock exchanges close and the fund manager can recalculate the fund’s NAV.
However, investors may find that mutual fund availability is more restrictive than major stocks like Nike or Apple. While major stocks are likely to be available on any trading platform from any company, some mutual fund companies actively restrict the availability of their products to encourage investors to invest directly with the company that issues the mutual fund shares.
If you haven’t opened a brokerage or retirement account already, do some research about which mutual funds you’d like to invest in. After that, ensure that you choose an account with an institution that offers access to those funds.
How To Invest in ETFs
Investing in ETFs is a bit easier than investing in mutual funds. The basic process is the same; an investor opens a trading account with a financial institution, researches ETFs, and places orders to buy and sell them. The difference between ETF investing and mutual fund investing is that ETFs trade identically to stocks. They trade on major exchanges from 9:30 a.m. EST to 4 p.m. Depending on your brokerage, you may also have access to after-hours trading that further extends that trading window.
Within the trading hours, investors can place any type of order to buy or sell ETFs. This includes market orders, limit orders, and trailing stop-loss orders. Traders can even place complex ETF orders, like selling ETFs short, and they can also trade ETF derivatives like options.
Invest While Keeping the Big Picture in Mind
Both ETFs and mutual funds are great options for investors who want to diversify their portfolio without extensively researching every single stock and bond they invest in. Whatever your investment goal, there’s probably both a mutual fund and an ETF out there designed to achieve it.
With all those options comes a lot of choices, and investors need to keep their overall financial situation in mind when they begin investing in ETFs and mutual funds. What amount of money can you afford to invest? How risky should you be with your investments? What period of time do you plan to leave your money in the market? These are personal questions that no one can answer for you. By carefully assessing yourself and your finances before picking a ETF or mutual fund (or both), you can help ensure that you maximize your benefits from these investments.