To make smart financial decisions, you need to know what investing tools are available and how investment vehicles are structured. Unfortunately, if you’re like most new investors, you’re probably struggling to understand and choose between two popular investment types: exchange-traded funds (ETFs) and mutual funds.
We’re here to help you weigh your options and determine the potential best investment options for your portfolio. In this article, we drill into ETFs versus mutual funds by identifying their similarities, pinning down how they are different, and explaining the advantages of each option.
Exchange-Traded Funds vs. Mutual Funds: How Are They Similar?
Because they hold similar financial structures, mutual funds and exchange-traded funds (ETFs) are easy to confuse. That’s because mutual funds and ETFs both invest in a collection of different assets and bundle them into a single investment package. The history of mutual funds stretches back to the 1940s, while the first ETFs were launched in the early 1990s as the next evolution of this investment vehicle. They are closely related in general structure. Here are a few more similarities shared between ETFs and mutual funds:
- Legal structure: Mutual funds and exchange-traded funds have similar legal structures and trade stocks, bonds, or commodities.
- Financial layout: ETFs and mutual funds let you invest in many securities at once through a single financial wrapper.
- Risk advantages: Mutual funds and ETFs spread your investments across several securities. Each opportunity can diversify your portfolio by dispersing risk through different holdings.
ETFs vs. Mutual Funds: How Are They Different?
While sharing broad structures, there are critical differences between ETFs and mutual funds. One of the most significant differences is that you can only buy and sell mutual funds when the trading day ends. Also, a mutual fund’s daily price is based on net asset value. Because mutual funds rely on net asset value to determine their worth, you need to wait until the end of the day to know how much your investment’s price has changed. That means you also can’t make trades throughout the day.
Alternatively, you can trade ETFs on an exchange the same way you would buy and sell individual stocks. So you can buy or sell an ETF throughout the day as its value shifts. This real-time price (intra-day liquidity, see below) may or may not be trading at the ETF’s net asset value.
Are ETFs or Mutual Funds a Better Long-Term Investment?
Although the differences between ETFs and mutual funds are often overlooked, they can impact the value of your investments in the long run. Here are a few advantages ETFs have over mutual funds if you’re an investor seeking long-term profit:
The difference in cost structure between ETFs and mutual funds means ETFs usually come with significantly lower fees. In general, mutual funds pass management fees, 12b-1 fees (such as marketing costs and employee bonuses), account fees, and other expenses of the fund to shareholders which decreases their annual return. While ETFs still have fees for investors, they don’t include 12b-1 fees are able to keep costs lower.
ETFs tend to offer significant tax advantages over mutual funds because of their use of in-kind redemptions. Basically, instead of trading underlying holdings on the exchange, ETFs can swap shares for underlying securities. Ultimately, trading securities in this way gives the fund tax breaks, whereas mutual fund holders may have long-term capital gains taxes to pay.
The exchange-traded fund’s unique cost structure lets you see its holdings more often than mutual funds. ETFs publish what assets and asset percentages the broader financial package includes at the beginning of each day. For passive ETFs, the holdings usually won’t vary much from day to day, but for instance, if you invest in an actively managed ETF, you may find that it includes a large percentage of a stock one day and only a small percentage of that same stock the next. By looking at the ETF’s daily holding makeup, you can see that information and act on it if it affects your investment goals.
However, mutual funds don’t give you that same view into specific holdings because they report quarterly. Throughout the quarter, you can’t see what assets are being traded within your mutual fund on a daily, weekly, or monthly basis.
One significant advantage of ETFs over mutual funds is how much liquidity they offer, meaning how easily an investment can be turned into cash. ETF liquidity comes from the underlying portfolio stocks. If the ETF is invested in companies that are liquid, the ETF is liquid. This works through the in-kind creation and redemption mechanism. So you can buy or sell as much of the ETF as you wish because the ETF will ultimately be trading those liquid, underlying securities. And since ETFs trade on market exchanges, they can be bought and sold throughout the day.
Mutual funds, on the other hand, can only be purchased or sold at the end of the day based on the net value of the underlying assets calculated at 4:00 pm eastern time. Depending on market conditions, it could be difficult to know the value of shares when the purchase or sell order is placed during trading hours.
Become an Investing Expert
No matter where you decide to invest your money, there’s one thing great investors share: knowledge. The more you know about how the market works and what tools you have at your fingertips, the easier it will be to invest. Want to become an investing expert? Subscribe to our blog, and we will send you the latest expert insights and tips.