If you’re a twin or have a sibling similar in age, chances are you were often mistaken for one another growing up.
The same happens with mutual funds and exchange-traded funds (ETFs). Both are basket-like investments that promote diversification, are professionally managed, can earn (or lose) money, and charge fees. But they also have distinctive attributes that make them special.
In the spirit of celebrating uniqueness, let’s examine mutual funds vs. ETFs and give each their due by acknowledging their similarities and comparing their differences.
Mutual funds and ETFs are both like baskets.
Have you ever pooled together money with a group of friends or family members to purchase season tickets for your favorite sports team? Or a boat that otherwise would be too expensive to buy on your own? Well, that’s sort of how mutual funds and ETFs work.
Mutual funds and ETFs both allow investors to buy a collection of stocks, bonds, or other securities they might not otherwise be able to afford. For example: If you want to own a share of Warren Buffet’s Berkshire Hathaway, Amazon, or Google parent Alphabet — stocks that cost four to six figures per share! — but don’t have the money, you could instead buy a mutual fund or ETF that owns shares in those three companies — and many others as well.
While those prices might scare you, don’t worry. Mutual funds and ETFs are more affordable, typically costing two to three figures per share. The reason mutual funds and ETFs can be more reasonably priced varies. But in general, it’s because you own smaller portions of larger companies after pooling your money together with other investors.
These types of investments are considered open-end funds since they’re always available for purchase — meaning there’s an unlimited number of shares available and new capital can always flow into the fund. Closed-end funds, on the other hand, are a group of assets that are used to raise a set amount of capital once through an initial public offering (IPO), then shares are traded like stocks on an exchange. In this article, we focus on open-end mutual funds and ETFs.
Some mutual funds and ETFs can also be classified as no-load funds — which means there’s no commission fee when you buy or sell them, because the funds are issued directly by the investment company. Some charge fees, which we’ll get to later.
In addition to giving you an opportunity to own parts of companies you otherwise couldn’t, mutual funds and ETFs also allow investors to take a hands-off approach to investing. Brokerages and investment companies manage the securities within mutual funds and ETFs, so you don’t have to worry about keeping track of each top-producing or under-performing company in your portfolio — that’s the fund manager’s job.
Both offer similar investment options.
More than 10,000 different mutual funds and ETFs are available in the U.S., so how do you choose what to invest in? Let’s start by separating them into three basic categories:
- Equity funds are fully invested in stocks and meant for investors looking for significant growth.
- Fixed-income funds are fully invested in bonds and designed for those who want to avoid the risk associated with stocks.
- Balanced funds invest in a mix of stocks and bonds.
While this list is a high-level overview of different mutual fund and ETF options, one of the more appealing aspects of these investment options is the range of subcategories you can choose from — another reason investors have poured more than $21 trillion into the U.S. mutual fund and ETF offerings.
Some of the most popular subcategories include:
Want to invest internationally but don’t know where to begin or which companies to invest in? There’s a mutual fund or ETF for that. Depending on the brokerage company you invest with, you may have a wide array of choices ranging from a total international fund — which includes investments from across the world — or funds comprised of assets from specific areas like Asia or Europe.
Also referred to as sector funds, these allow investors to put their money in specific areas of the economy. Convinced big tech companies like Netflix and Apple aren’t finished growing? Consider a technology fund. Think baby boomers are going to need increased care as they grow older? Research healthcare funds, which might include companies like UnitedHealth Group Inc., Johnson & Johnson and Pfizer, Inc. Other funds include ones geared toward finance, industry, and real estate, to name a few.
Novice investors might have heard names like the Dow Jones Industrial Average and S&P 500 and thought, “Just put my money there.” Actually, the Dow and S&P 500 are indices that track hundreds of different companies and weren’t investment options — until index funds came along. Thanks to index mutual funds and index ETFs, investors can replicate the daily movements of the stock market as a whole rather than risk purchasing individual stocks. Index funds are designed to do no better or worse than the market itself, and since the market has shown to rise pretty consistently over the long run, this can be an attractive strategy.
The differences: Mutual funds vs ETFs
On the surface, mutual funds and ETFs appear to be the same. In fact, ETFs evolved from mutual funds as investors sought products with different features, such as lower fees. But just as you and your sibling might have varying color eyes, hair, or body types, mutual funds and ETFs also have their differences.
ETFs are very similar to stocks in that their price fluctuates daily and investors can buy and sell shares at any point during the trading day.
In contrast, the price of mutual funds is set once every 24 hours at the end of each trading day. This is when their price is determined by the total value of the portfolio divided by the number of shares — otherwise known as net asset value (NAV).
So, while you can submit purchase orders for mutual funds throughout the trading day, you won’t know the actual purchase price until day’s end.
Minimum and automatic investments
While buying mutual funds and ETFs can sometimes be cheaper than purchasing one share of a large company, some mutual funds require a minimum investment. These vary per brokerage and can be as low as $100 or as high as $5,000 — or more.
Since ETFs are traded like stocks, the minimum amount you need is the price of the single ETF share you’re looking to purchase, plus any commissions your broker charges. Most brokers will even offer commission-free ETFs. With Ally Invest, you can trade hundreds of commission-free ETFs though a self-directed trading account.
If you like to take a more hands-off investment approach, you might consider investing in ETFs through an Ally Invest Managed Portfolio. With only a $100 minimum to get started, you can have a professionally-managed portfolio full of diverse ETF investments selected specifically to help you reach your money goals. And by opting to allocate 30% of your investment into an interest-bearing cash buffer within your portfolio, you’ll pay $0 in advisor fees.
If you’re looking to make automatic investments — for a retirement fund or saving for your children’s college — mutual funds are the more suitable option since many of these accounts don’t permit you to invest in ETFs.
The hands-off investing associated with mutual funds and ETFs does come with a cost in the form of fees.
Mutual fund and ETF fees are grouped into what’s called an expense ratio. This includes fees for redemptions, purchases, and even a shareholder fee. The average mutual fund carries an expense ratio of 0.74 percent, while the average ETF’s expense ratio is 0.44 percent.
The expense ratio depends on a number of factors — brokerage, type of fund, whether the fund is actively managed. Since they’re generally passively managed (which means less work for the fund manager), ETFs typically have fewer fees and lower expense ratios.
And while 0.3 percent (the difference between the average mutual fund expense ratio and the average ETF expense ratio) might not seem like a lot, every bit counts.
Consider this example from Investor.gov: If you invested $10,000 in a fund with a 10 percent annual return and annual operating expenses of 1.5 percent, after 20 years you would have roughly $49,725. If you invested in a fund with the same performance and expenses of 0.5 percent, after 20 years you would end up with $60,858.
We saved the “best” for last. Taxes. Yes, you do have to pay taxes on capital gains and dividend income if you sell mutual funds or ETFs for a profit. But ETFs are usually more tax efficient than mutual funds because they experience fewer taxable events. In essence, this is because a mutual fund manager must constantly re-balance the fund, as opposed to an ETF manager, who accommodates for investment inflows and outflows.
The case for mutual funds
Mutual funds are a great way for everyday investors to have access to professionally managed funds at a relatively low cost. They can be less risky than individual stocks because your money is spread out between hundreds (if not thousands) of different stocks and/or bonds within the fund, and you can choose to invest in numerous funds.
For those with long-term goals — retirement, college savings, etc. — investing in mutual funds could be an ideal investment strategy.
The case for ETFs
ETFs can offer all the benefits of mutual funds — professional management, diversification, a plethora of options — for lower fees and more tax efficiency. They’re also typically cheaper than mutual funds, and they offer more flexibility since they can be bought and sold just like stocks.
Invest in mutual funds and ETFs today.
While you and your brother or sister might have butted heads as children, there’s no sibling rivalry when it comes to mutual funds vs. ETFs — even if they’re often confused with one another. Diversification is key when it comes to investing, so consider buying both mutual funds and ETFs in order to better spread out your money and maximize your return.
Diversify your portfolio with mutual funds and ETFs.