Mutual Funds vs. ETF: Definitions

Table of Contents:

  1. Mutual funds and ETFs
  2. ETF vs. mutual funds similarities
  3. ETF vs. mutual fund differences
  4. ETF vs. mutual fund
  5. ETF or mutual fund: Which one is right for you?
  6. The bottom line

When learning how stocks work, you discover there are various options for investing, and two of the most popular are mutual funds and exchange-traded funds (ETFs). Both are pooled funds that allow investors access to professionally managed funds that offer diversification in a wide variety of asset classes and industries.

Key takeaways

  • One significant difference between mutual funds and ETFs is that ETFs can be bought and sold just like stocks during regular stock market hours. In contrast, mutual funds can only be purchased at the end of the trading day.
  • ETFs and mutual funds can be actively or passively managed. ETFs are usually passively managed, while mutual funds are typically actively managed.
  • Fees largely depend on fund management styles. Generally, passively managed funds have a lower expense ratio than actively managed funds.
  • Net asset value is the value of a company’s assets minus its liabilities. It’s often used when referring to ETFs and mutual funds.

Mutual funds and ETFs

Mutual funds are a type of financial asset that include stocks, bonds, and money market funds that are bundled together in a single mutual fund. They offer investors a way to own a diversified portfolio of investments at a lower price than would be possible if they owned each investment separately. They are managed by professional money managers who allocate the funds intending to produce income or capital gains for investors.

There are 2 types of mutual fund classifications that include:

  • Open-ended funds – which are the most notable, are purchased between the investor and the fund brokerage. The fund can issue unlimited shares, so as investors purchase the fund, shares are issued.
  • Closed-end funds – are funds that only allow a specific number of shares to be sold, so no new shares are issued despite investor interest.

Exchange-traded funds (ETFs) are pooled investments of stocks, bonds, or other commodities similar to mutual funds, except they can be bought and sold on the stock exchange much like stocks. EFTs may track a specific index or sector by a single investment or an assortment depending on investment strategy.

As with investment companies, both ETFs and mutual funds are required to be registered with the securities and exchange commission (SEC), offer a wide variety of diversified investments, are managed by professional money managers, and, like all investments, have risks associated with them.

ETFs include 3 classifications that include:

  • Exchange-Traded Open-End Fund – registered under the Security and Exchange Commission’s (SEC) Investment Company Act of 1940, the structure has requirements for diversification that limit the percentage of stock that can be invested in a specific stock as part of the fund’s portfolio of investments. Due to this requirement, the fund manager has more flexibility in choosing funds as they don’t have to recreate the index.
  • Exchange-Traded Unit Investment Trust (UIT) – is also registered under the Security and Exchange Commission’s (SEC) Investment Company Act of 1940. Still, unlike the exchange-traded open-end fund, the aim is to completely replicate the specific index such as the S&P 500.
  • Exchange-Traded Grantor Trust – is registered under the Securities Act of 1933 but not registered under the Security and Exchange Commission’s (SEC) Investment Company Act of 1940. It’s similar to the close-ended fund except that the investor owns the shares in the ETF, which can include voting rights as a shareholder.

ETF vs. mutual funds similarities

One of the most notable similarities when considering mutual funds vs. ETFs is they are both professionally managed baskets of funds. Since they are managed by experts, they do the research, oversee the funds, and make sure they stay on track with the target indexes. As an investor, it’s important to understand how stocks work and research the investments included in the fund you’re interested in.

They are also both automatically diversified due to the number and variety of stocks, bonds, and other securities included in the collection. Due to the diversification, many investors consider them to be less risky because when one stock or bond isn’t performing well, others can offer a more balanced portfolio and reduce risk.

Another common trait is that investors have a large variety of U.S. and international investments to choose from that can be focused on a specific industry, such as sector funds or on total market funds, which provide a large variety of investment choices in various markets and industries.

ETF vs. mutual fund differences

Although each of these types of investments is constructed in baskets of funds and has various similarities, they also have some significant differences that include:

Management styles, including active management and passive management.

For the most part, mutual funds are considered to utilize active management, where the fund manager uses their experience to actively engage in buying and selling to beat the market, which can translate to higher costs for investors.

On the other hand, ETFs generally use passive management, where funds are automatically tracked on the Nasdaq or the S&P 500. Although there are some exceptions, the costs are usually higher.

Trading style – When we think about the trading day, we usually just figure we can trade as long as we do it during regular stock market hours, which is true for ETFs. Although they are funds, they can be traded throughout the trading day, just like stocks with pricing based on supply and demand. However, mutual funds are traded differently. The price is set, and they can be traded only at the end of each trading day, not during it.

Investment minimums – Not all investments require a minimum to invest. Still, a significant difference between ETFs and mutual funds is the cost to purchase. While ETFs can be bought by the share, allowing an easier, less expensive way to buy and enjoy a diversified portfolio, mutual funds can routinely have a minimum investment of $1000 or more, making it difficult for beginning investors to gain entry into mutual funds.

The way they’re taxed – ETFs may be more tax-efficient since they are passively managed with lower expense ratios. But, since mutual funds are actively managed, the securities that make up the fund are bought and sold actively, and sometimes incur gains. When that occurs, capital gains taxes are passed to all investors who own shares in the fund, whether they’ve sold their shares or not.

ETF vs. mutual fund

When the goal of investing is diversifying your portfolio, there are a few strategies to consider when learning how to invest in stocks, which includes understanding mutual funds vs. ETFs vs. index funds.

  • Mutual funds – as discussed, mutual funds are made up of stocks, bonds, and money market funds. They are typically actively managed by professional money managers who hand-pick the investments and buy and sell them to make a profit for their clients for an investment fee.
  • Index funds – are a type of mutual fund or ETF that employ a different strategy. Instead of the money manager choosing individual stocks, they buy all the shares that make up an index, such as the S&P 500, to attempt to reproduce the performance of the market.

Since index funds are usually held after purchase instead of actively bought and sold, no analysts are needed, making fees lower overall. Earnings also tend to be the average rate of returns, which, for many investors, is the long-term strategy they’ve aimed for.

  • ETFs – include multiple investment types such as stocks, bonds, and others that can be made up of hundreds of stocks in various industries. They’re listed on the exchange and bought and sold, much like stocks with prices that vary during the trading day as they are bought and sold.

ETF or mutual fund: Which one is right for you?

When deciding whether an ETF or mutual fund is the best option for you, it’s important to consider your investment style. Since they have similarities, determining your choice can come down to the types of stocks and bonds in the fund, whether you want an actively or passively managed fund, the fees and commissions you’re willing to pay, and the returns you’re looking for.

Especially for the beginner investor, it’s always important to do your research, so you understand the costs involved in both options and check for any unforeseen fees. Both ETFs and mutual funds offer ways to diversify your portfolio.

ETF vs. mutual fund FAQs

Q: What are the notable differences between ETFs and mutual funds?

A: While ETFs trade in a similar way to stocks during regular stock market hours, mutual funds are only available to trade once a day at the end of trading hours.

Q: What type of investment is better for a hands-on investor?

A: ETFs offer greater flexibility in trading and allow investors to choose smaller niche stocks, while mutual funds are better suited for investors who don’t want to manage their own fund(s).

Q: What are the advantages of investing in actively managed mutual funds over ETFs?

A: Professional money managers offer a set of skills that most investors don’t have, so having a professional set the investment strategy and manage the fund is a benefit for many investors who don’t have the time or knowledge to do it themselves.

Q: What are the advantages of passively managed ETFs over mutual funds?

A: ETFs have all fund information available online, so researching different funds is easy and offers investors more control over their portfolios.

Q: I want to make my investments automatic. What’s a good option?

A: An active mutual fund can be a good option since many firms don’t charge a transaction fee. Of course, you’ll want to do your research to be sure it’s the right choice for you.

The bottom line

Both ETFs and mutual funds offer a variety of benefits for investing as well as diversification. For investors that enjoy simplicity, ETFs offer a low-cost, easy way to get started with options in various markets that can provide a well-balanced and diversified portfolio geared to long-term investing.

On the other hand, mutual funds offer the opportunity to invest in smaller markets and specific niches that may be suited for investors looking for even greater diversification.

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