Exchange-traded funds (ETFs) and mutual funds have many similarities between them, and both offer an excellent opportunity for investors to diversify their portfolios. The main difference between the two lies in the way they are actively managed. ETFs are traded like any other stocks throughout the day, while for mutual funds, an investor has to purchase at the close of the day at the prevailing calculated price. While ETFs are based on market index funds, the fund manager of a mutual fund decides on asset allocation. Mutual funds, though, have an edge in popularity market penetration. While there are 8,059 mutual funds with $17.7 trillion asset value, ETFs are 1,998 and $3.37 trillion, respectively.
A detailed look at each will help understand which one is better.
The first striking point is that mutual funds require a higher minimum investment than ETFs, depending on the type of funds and company. For example, the P 500 Index Investor Fund requires $3,000, while the Growth Fund of America requires an initial deposit of $250. Most mutual funds are actively managed by a fund manager who takes all the key decisions to buy or sell stocks and securities within that fund to increase investors’ profits. These funds have a higher price tag since the cost of managing the fund or expense ratios are higher.
Mutual funds are bought and sold directly by the investors from and to the fund, with the price being decided at the close of the business day after the net asset value (NAV) is determined.
Mutual Funds are classified into two legal entities.
- Open-ended funds – This type of fund dominates the mutual fund ecosystem. The purchase and sale of fund shares are made directly by the fund company and the investors with no limit on the number of shares that can be issued by the fund. Hence as more investors come into the fund, more shares are issued. A daily valuation process known as the markings to market is required as per Federal regulations. This helps to adjust the pre-share price of the fund to reflect the portfolio (asset) value changes. However, an investor’s shareholding value is not affected by the outstanding number of shares.
- Closed-end funds – A specific number of shares are issued by the fund only and are not scaled up or down as per investors’ demands. Prices do not depend on the NAV but the demand. Shares are often purchased at a premium or discount of the NAV.
Exchange-Traded Funds (ETFs)
The entry position of ETFs is far less than mutual funds, often the cost of one share plus commissions and fees. The shares trade throughout the day between investors as in stocks and are redeemed or created in large lots by institutional investors and can be sold short. Since the price of ETFs changes continually in the market, trading often takes place at a price that is not the NAV, thereby increasing arbitrage opportunity.
ETFs tend to bring in fewer capital gains than actively managed mutual funds and offer a greater tax advantage to the investors.
ETFs are classified into three components.
- Exchange-Traded Open-End Index Mutual Fund – The fund is registered under the Investment Company Act of 1940 of the Securities and Exchange Commission (SEC). Dividends are reinvested the same day as their receipt and reimbursed to shareholders every quarter in cash. The lending of securities is permitted, and the use of derivatives in the fund is allowed too.
- Exchange-Traded Unit Investment Trust (UIT) – The Investment Company Act of 1940 also governs the Exchange-traded UITs, but there are major differences with the Open-end funds. Here, there should be an attempt to duplicate their particular indexes, restrict investments to 25% or less in a single issue, and set more weighting limits for non-diversified and diversified funds. Unlike the Open-end funds, dividends are not reinvested automatically but paid in cash every quarter.
- Exchange-traded Grantor Trust – This fund is similar to the closed-end fund in many ways. But in this fund, the investor owns the companies’ shares where the ETF is invested and enjoys the perks like the voting rights of a shareholder. Dividends are paid directly to the shareholder and not reinvested. The trading lots are in 100 shares.
ETF vs. Mutual Fund – Differences
While a comparison between ETF and mutual fund throws up several similarities, there are also a few key differences. Given here are a few of them.
- Mutual funds cannot be purchased directly, and a request for buying has to be placed with the fund manager of actively managed funds, while ETFs that are traded freely in the market can be bought or sold at any time.
- Mutual funds units are traded at the end of the day only, whereas there are no restrictions on ETFs. An investor can place buy/sell orders at will.
- ETFs do not have a lock-in period, whereas a mutual fund can be anywhere between 9 days to 3 years, depending on the scheme.
- Mutual funds have higher fund management fees or expense ratios as they are actively managed funds, but ETFs have no such fees as they do not have to be managed.
- More tax benefits are available to ETF investors as against mutual funds due to the manner of redemption and creation.
- In ETFs vs. Mutual Funds, the latter monitors the index funds, but how it selects the assets depends on how they can beat the index and yield consistent performance. ETFs match the P 500 index price and give a portfolio that is the same as the index funds constituents.
Which is superior – ETF vs. Mutual Fund?
A comparison of ETFs vs. Mutual Fund shows that both offer a rich experience to those who want to create a diversified portfolio. But depending on risk appetite, financial objectives, and the time-frame, the option has to be decided. The difference is clear for people who prefer quick liquidity investments over long term investments. But investors opting for a judicious mix of ETFs and Mutual Funds are the ones who are most benefited. Before making any decision, though, it is essential to understand how both these funds work, assess the level of risk that can be taken, and consult an expert for guidance.
There is no clear answer to which is superior between ETFs and mutual funds. At most, a comparison may be made on some key parameters as given here.
- Taxation – This is a major advantage of ETFs over mutual funds. Due to its attributes, ETFs accrue capital gains and incur capital gains tax but only when they are sold. On the other hand, mutual funds incur capital gains taxes whenever the shares are traded within the lifecycle of the investment with all rights reserved. In mutual funds vs. ETF, choosing an ETF can reduce the tax bill on long term investments.
- Easy to Operate – Buying or selling ETFs is done in one easy transaction at one price and only a single deal away from an open or close position in the market. However, doing so with mutual funds, though not complicated, requires calling customer service, completing some paperwork, and then waiting for some time for the transaction to be green flagged.
- Cost-effective – ETFs are more cost-effective than actively managed mutual funds. ETFs are mostly a passively managed set up to monitor the achievement of a specific benchmark. Mutual funds are often actively managed for which a fee is charged. While fund managers must charge a fee, it is possible to get short or long term maximized returns with low-cost ETFs.
- Transferability – ETF scores higher over mutual funds in ease of transfer. If an investor wants to move a managed portfolio to another investment firm, the mutual fund must be closed before the transfer goes through. This might force traders to go in for untimely and unwarranted trades that might lead to losses. An ETF, on the other hand, can be switched to another firm effortlessly and is therefore often called a portable investment.
- Research – Any investment, whether ETF or managed funds, should be researched thoroughly before committing money to it. The due diligence should include how the fund behaves in various market conditions and a detailed analysis of the assets held in the funds. If a market beginner cannot understand these aspects, it is always advisable to get in touch with a financial industry professional or a chartered financial advisor. The finer points of ETF and managed funds should be well –understood first before investing any amount.
- Long-term Benefits – Both ETF and mutual funds are good in the long-term, and a lot depends on the assets that are a part of the fund. For example, both based on the S&P 500 Market Index will perform equally well. But the differences arise when fees and commissions pile up over the years in funds that are actively managed. That can make a lot of difference in the long run.
- Safety – Neither ETF nor mutual funds can be safer than the other as both are subject to the usual market risks. The safety factor is based on the assets owned by the respective fund. However, by a rule of thumb, stocks are riskier than bonds, and in that too, US Treasury bonds are less risky than corporate bonds. On the flip side, financial instruments with a high-risk level deliver greater returns.
Summing up, it seems that ETFs are usually a preferred option as it offers several benefits like low commissions, tax advantages, and easy tradability. But in certain cases, like stock index instruments, mutual funds are more cost-effective than ETFs. In any case, the investor should know where the funds are invested and how that can help achieve the set financial goals.
Why choose an ETF over a mutual fund?
There are several reasons for choosing ETFs over the other. One is tax benefits as it incurs capital gains tax only when it is sold. Next, ETFs are easy to operate, and buying or selling them can be done in one deal, unlike mutual funds where elaborate paperwork is needed. Mutual funds have higher fees and commissions as management fee is charged during the lifecycle of the fund. Hence ETFs are considered a more attractive investment channel.
Do ETFs outperform mutual funds?
There is nothing much to prove that ETFs outperform mutual funds in the market conclusively. The performance of a fund is dependent on the type of assets and asset quality. So far as cost-effectiveness is concerned, While ETF is considered ahead; however, in the case of stock index instruments, the other performs well and is more cost-effective.
Are ETFs or mutual funds better for Roth IRA?
If investors save in a Roth IRA for retirement, both an ETF and mutual fund can be an excellent investment option. Even though they help diversify investment portfolios, both have different goals regarding management costs, market objectives, and management styles.