Exchange-traded funds (ETFs) and mutual funds are alike in that both offer diversification and professional management. Otherwise, the two investment vehicles differ greatly.
Here's a closer look at the difference between ETFs and mutual funds so you can identify the best investment for your particular goals.
The Difference Between ETFs and Mutual Funds: 10 Criteria
The first step in choosing between ETFs and mutual funds is to identify your own personal investment horizons and objectives. Specify your savings and investment goals, and determine whether you're an active trader or retirement investor. Then you can make your choices based on the following 10 differences between ETFs and mutual funds...
ETF vs. Mutual Fund: Buying and Selling - ETFs can only be purchased and sold through a brokerage account. Mutual funds can be bought and sold directly from a mutual fund company, such as Vanguard or Pimco.
ETF vs. Mutual Fund: Trading and Pricing - ETFs can be traded on major stock exchanges anytime during regular trading sessions. Mutual fund buys and sells are executed and priced once a day after the markets close.
ETF vs. Mutual Fund: Transaction Costs - Investors typically pay a commission when buying and selling ETFs. Commissions vary depending on the trade size and brokerage firm. A number of investment houses, however, offer a cache of commission-free ETFs. Charles Schwab has more than 200. Ameritrade has more than 100. Fidelity offers over 70. It should be noted that ETFs falling into the commission-free category are limited in sectors covered. They can also sport additional fees, and their expense ratios differ. The typical ETF expense ratio is a modest 0.44%, according to Morningstar.
Mutual funds, meanwhile, are front- or back-end loaded or are no-loads. Investors pay a fee when buying a front-end-loaded fund. With a back-end fund, investors pay a deferred sales charge when selling. This charge declines over a certain time frame. No-load funds don't carry a sales charge. But like all mutual funds, they have ongoing annual fees that can chip away at returns. Expense ratios range from as low as 0.2% (typically for index funds) to as much as 2%. The average equity mutual fund charges around 1.3% to 1.5%. Specialty or international funds, which require more expertise from management, generally carry higher fees.
ETF vs. Mutual Fund: Automatic Investing - ETFs do not have automatic investment options. Many mutual finds allow investors to purchase additional shares at specified intervals by moving money directly from a back account. Many also allow regular redemptions, with money sent directly to an indicated account.
[epom key="ddec3ef33420ef7c9964a4695c349764" redirect="" sourceid="" imported="false"]ETF vs. Mutual Fund: Exchanging One Fund for Another - When investors decide to get out of one ETF and move into another, they must sell their ETF position and buy the new ETF. Many mutual funds allow investors to exchange all or partial shares from one mutual fund into another fund within the same family. For example, you can exchange shares from the Vanguard Growth and Income Fund into the Vanguard U.S. Value Fund.
ETF vs. Mutual Fund: Minimum Investments - ETF purchases can be for a single share. Mutual funds tend to have minimum investment amounts, which can range from $250 up to $10,000.
ETF vs. Mutual Fund: Capital Gain Distribution - When a mutual fund or ETF sells securities, a capital gain is generated. These sales come from rebalancing or to meet shareholder redemptions. When funds accrue capital gains, they are required to pay them out to shareholders at the end of each year. Since most ETFs are index funds, most have very little turnover and thus fewer capital gains. That's not the case with actively managed mutual funds. Long-term capital gain distributions are taxed at long-term capital gains tax rates. Distributions from short-term gains are taxed as dividends at ordinary income tax rates. Ordinary income tax rates are generally higher than long-term capital gains tax rates.
ETF vs. Mutual Fund: Tax Efficiency - ETFs are also more tax-efficient than index mutual funds. When a mutual fund investor decides to sell shares, the mutual fund must sell securities to raise cash to meet that redemption. When an individual investor sells an ETF, shares are simply sold to another investor like a stock. As such, they reduce taxable capital gains.
ETF vs. Mutual Fund: Transparency - A key benefit of ETFs is that they offer better transparency of their holdings than competing mutual funds. Mutual funds are only required to disclose their portfolios on a quarterly basis - and then only with a 30-day lag. In between reporting periods, investors have no idea if the mutual fund is invested according to its prospectus or if the manager has taken on unwanted risks. Mutual funds can and do stray from their described targets. This is called "style drift," and it can negatively impact an investor's asset allocation plan. ETFs are far more transparent. Most ETFs disclose their full portfolios on public, free websites every day of the year.
ETF vs. Mutual Fund: Active or Passive Management - Mutual funds appeal to fans of active management. Most ETFs passively track an index rather than attempting to beat the market with unique strategies or guru stock picking.
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