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In this new day of age, the ETF is the latest rage. The mutual fund used to be the go-to for individual investors as they sought ways to have more diverse allocations. The ETF is leading the charge with innovation, tech, and ease of trading with lower costs. So what's the difference between the ETF vs Mutual Fund.
ETFs and mutual funds pool money together from investors to buy a set of stocks. This helps with diversification and creates a better way for investors to invest without the risks associated with holding on to a low number of stocks.
Many of the ETFs discussed stem from famous mutual funds or are made up to track an index. For instance, SPY and VOO are ETFs that track the S&P 500 index. VOO happens to be the ETF version of Vanguard's VFIAX, the mutual fund version of the S&P 500.
Do not get confused with mutual funds and index funds. Index funds are just a type of mutual fund that tracks an index and is passively managed. Mutual funds can be passively managed or actively managed.
ETFs have risen in the last ten years with the low cost associated with them. There are no longer mutual fund minimums that you have to put forth to get the mutual fund, but the expense ratios are much lower.
So what are ETFs, and what are mutual funds?
What Is an ETF?
ETF stands for exchange-traded funds. ETFs are a way to hold an extensive portfolio of different companies. So they are like a mutual fund but are traded throughout the day like a stock. There can be buy and sell orders just like a stock. Mutual funds are typically purchased and sold at the end of the trading day.
ETFs are typically managed passively, which gives more savings to the investor. The ETF will have a much lower cost or expense ratio associated with it. As the fund is managed more passively without the buying and selling securities, there will be fewer costs associated with paying people to manage the fund. There will also be fewer expenses accrued as securities are bought and sold. They are an excellent investment to invest in.
What Is a Mutual Fund?
A mutual fund is a type of fund that hosts a pool of securities for a specific allocation. They may be more centered around growth, sectors, or another kind of allocation. Mutual funds are like the older version of an ETF. They are typically actively managed, except for those that are index funds. With active management of the mutual fund, the fund managers seek to outperform the index. In 2021, 85% of hedge fund managers could not beat the S&P 500 Index.
Mutual funds have a more significant cost basis than ETFs. They incur many different costs as managers buy and sell securities throughout the day. The buying and selling pose additional charges to the investors who hold the mutual funds in their investment portfolios.
There are also minimums to get into mutual funds. Even if they are index funds, brokerage companies still have minimums on their funds. Vanguard has excellent index funds, but each fund has a $3,000 minimum to get started investing in that particular mutual fund. The ETF version is just the cost of 1 share, making it easier to start investing.
Trading the mutual fund takes place at the end of the trading day. You buy the fund, and the price is set at the end of all the trades that have taken place. That is slightly different from the ETF, as you can buy and trade the ETF during the day, with the price going up and down as the market moves.
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What Are the Differences Between an ETF vs Mutual Fund?
Here are a couple of differences between the ETF vs Mutual Fund.
- Active Management vs Passive Management
The mutual fund is usually actively managed, and their fund manager seeks to beat an index like the S&P 500. ETFs usually are more passively managed and track or mirror indexes. Having passive management allows the ETFs to have a lower cost basis than the mutual fund.
Mutual fund managers can create short-term success that beats an index for a good long time, but eventually, the passive, low-cost ETF will win in the end.
People see the results of a great investor and try to hop on. Peter Lynch managed the famous Fidelity Magellan Fund, which averaged 29% for the 13 years he ran the fund. According to Fidelity, the average investor lost money investing in the Magellan Fund. Peter Lynch only managed the fund for 13 years, which is a short time in our investing journey, but then it moves onto another manager.
With ETFs, you will not have to worry about the short-term turnover of managers. The ETF is managed passively. Some ETFs like Cathie Wood's ARKK are actively managed. That also comes with a much higher expense ratio associated with the fund's management.
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An ETF vs mutual fund is all about how you like it managed. Would you rather have it actively managed or passively managed?
- The Fund Expense Ratios
An expense ratio is an expense that is associated with the fund. For example, VTI, a Vanguard Total Stock Market ETF, has an expense ratio of 0.03%. That means it costs you $3 for every $10,000 invested into the ETF. A mutual fund could have a higher expense ratio like 0.50%-2%. As you can see, those costs start eating into your performance.
1% of a $10,000 portfolio is $100. As these fees accumulate, you will start to lose out on performance over time. A $1,000,000 portfolio with an expense ratio of 1% costs $10,000. An ETF with an expense ratio of 0.10% will only cost you $1,000. That is a massive difference in your investing. You are losing $10,000 to fees every year for having a million dollars invested in a massive chunk.
ETFs may not always be the cheapest thing out there. It would help to compare the expense ratios with ETF vs mutual funds. Index funds are a great example. Vanguard has prided itself in having lower costs. State Street's SPY, S&P 500 ETF, has an expense ratio of 0.09%. Vanguard's VFIAX, S&P 500 Index Fund, has an expense ratio of 0.04%. That is a difference.
- How the ETF vs Mutual Fund is Traded
ETFs are traded throughout the day like a stock. As people are buying and selling, the ETF price is constantly going up and down a few cents to a dollar.
A mutual fund will have all its prices set at the end of the day. As the stocks in the fund are traded, that will affect the mutual fund's price. There is no buying and selling like a stock.
The buying and selling of ETFs could mean you may have to pay a commission. Right now, most brokerage companies do not have commissions. There are a few that still do. You can use Vanguard, Fidelity, Schwab, or M1 Finance and incur no commission costs as you buy and sell.
- Tax Efficiency with the ETF vs Mutual Fund
Taxes are a thing most people try to avoid. The structure of the ETF makes it more tax-efficient than the mutual fund. If you an ETF for again, you will pay taxes on that, but you are likely not to incur any taxes if you hold onto the ETF.
A mutual fund that is actively managed may buy and sell securities throughout the day and incur gains, which they will pass on to the fundholder. You may not sell the mutual fund, but you will end up having a short-term or longer-term capital gains tax that you would have to pay.
Selling individual shares of the ETF makes it easier to do some tax loss and tax gain harvesting within a taxable account. You can sell them at a price that helps with taxes.
- Minimum Investments Needed
One of the most significant differences between the ETF vs mutual fund is the minimum investment required to invest. Many mutual funds need a minimum investment to start investing. For instance, Vanguard's VFIAX requires a $3,000 minimum investment to start investing. VOO, the ETF of VFIAX, only involves the ETF price.
With many platforms starting fractional shares, you can do fractional shares of ETFs on platforms like M1 Finance. This helps you start investing with little money and create a more extensive portfolio. Some Robo-advisors also use fractional shares to create portfolios for their clients.
ETF vs Mutual Fund: Which One Should You Choose?
Should you choose an ETF or mutual fund? That is an excellent question to ask. It is all up to you, and ETFs and mutual funds are pretty similar. If you pick an ETF or a mutual fund that tracks the S&P 500, they will be similar and have identical performance.
The difference comes down to ETFs vs active managed mutual funds. The costs and fees that may occur with the actively managed mutual funds may be the most critical deciding factor. Keeping everything at a low cost helps your portfolio to perform very well.
The tax efficiency of the ETF is also a consideration, especially in taxable accounts. In tax-advantaged accounts like the Roth IRA, the tax efficiency is not a worry.
A choice between an ETF vs mutual fund can be a hard one. Make sure to consider the costs of each option. Some index fund mutual funds have a lower expense ratio than an ETF.
Generally speaking, a passively managed ETF that tracks an index is typically a safe bet. They have lower fees, are more tax-efficient, and help create a better portfolio. You can also trade them throughout the day.
The choice is yours. Which one would you choose, the ETF or the mutual fund?
This article was originally posted at The Frugal Expat and republished with permission.
Steve Cummings is the founder of the personal finance blog The Frugal Expat. As a traveler and expat, he has learned a lot about how to save money, live frugally, and invest for the future. His mission is to help people in saving, investing, and reaching financial independence.