ETF vs Mutual Fund: What’s the Difference?
If you’re an investor looking to gain exposure to the stock market, you’ve probably already come across exchange-traded funds (ETFs) and mutual funds as options for investing.
Both ETFs and mutual funds have become increasingly popular in recent years, but many investors still find it confusing to distinguish between these two types of investment vehicles. In this article, we’ll explore what sets these two investment options apart, their pros and cons, and how you can choose between them.
What are ETFs?
An ETF is a type of investment fund that trades on stock exchanges much like a stock itself. It’s composed of a basket of securities such as stocks, bonds, or commodities and seeks to track an underlying index or benchmark.
The biggest advantage of ETFs is their low cost compared to traditional mutual funds. They have no load fees or sales commission like mutual funds and typically charge lower expense ratios than most actively managed mutual funds.
In addition, another significant benefit that ETFs offer to investors is liquidity. Since they trade on stock exchanges during trading hours like any other stock, investors can buy and sell them instantly at market price anytime during trading hours.
What are Mutual Funds?
Like ETFs, mutual funds allow investors to hold a diversified portfolio made up of different individual securities managed by qualified professionals with expertise in choosing and managing investments. The main difference between mutual funds and ETFs is how they trade.
Mutual funds are priced once per day after markets close, based on the net asset value (NAV) calculated using the total value of all assets held in the fund divided by the number of outstanding shares. Unlike ETFs that trade throughout the day at market prices determined by supply & demand via buyers & sellers.
The primary advantages of mutual funds are professional management combined with diversification that reduces your risk exposure even further than holding individual securities making owning a single share provide adequate diversification and asset allocation. Mutual funds are a good choice for investors who don’t want to actively manage their investments, but still want professional management of their assets.
ETF vs Mutual Fund: Pros and Cons
While mutual funds and ETFs offer similar benefits, they also have their distinct pros and cons:
Pros of ETFs:
– Lower expense ratios
– Greater liquidity
– Traded like stocks with real-time pricing
– More tax-efficient than mutual funds
Cons of ETFs:
– Trading fees may apply if you are not using commission-free trades
– Bid–ask spread may be higher during times of market stress causing some investors to pay more than what is ideal.
– Some ETFs can be thinly traded that could cause in market orders to be filled at less desirable prices do to a lack of trading volume associated with the fund.
ETF vs Mutual Fund
Pros of Mutual Funds:
– Professional management by investment managers
– Offer better diversification
– May offer more consistent returns over long periods
– No trading fees apply
Cons of Mutual Funds:
-The underlying assets within the fund may not align with your individual investment philosophy or values.
-Sales charges (front-end or back-end loads) may apply which can reduce overall returns.
-Mutual funds are less tax-efficient due to daily purchases & sales within the fund causing realized gains throughout the year even though as an investor you personally have not sold any shares.
Which One Should You Choose?
The key difference between ETF vs mutual fund is their pricing and day-to-day tradability on the stock exchange. If you’re looking for access to the stock market at a low cost, while maintaining flexibility with no additional trading fees – choose an ETF. However, if you’re seeking professional management & broader diversification in your portfolio then a mutual fund is likely the correct option for you.
At the end of the day, it’s up to each individual’s goals and beliefs combined with their unique risk tolerance and investment time horizon to determine which option serves them best. In addition, investors should review the funds personal attributes, regulatory requirements, bid-ask spreads & expense ratios to gain a better understanding of each effective alternatives before making any final decisions.