When it comes to stock investing, there’s more than one way to do it. Buying stocks directly is good; sometimes, buying stocks indirectly is equally good (or even better) — especially if you’re risk-averse. Buying a great stock is every stock investor’s dream, but sometimes you face investing environments that make finding a winning stock a hazardous pursuit.
For 2022–2023, prudent stock investors should definitely consider adding exchange-traded funds to their wealth-building arsenal. An exchange-traded fund (ETF) is basically a mutual fund that invests in a fixed basket of securities but with a few twists.
In this article, I will show you how mutual funds (MFs) are different from (and similar to) ETFs.
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Mutual Funds
Mutual funds are one of the oldest investment vehicles that have been in the market. These are issued by financial corporations. Here’s how they work: The corporation creates a fund with a certain investment mandate. This could be anything from capturing dividends in small-cap stocks to buying the largest stocks in a certain country or creating a well-diversified portfolio that invests in everything.
A single unit in the fund is effectively what a share is when speaking of a stock purchase. The fund invests the money it has into stocks of various companies, and all of these underlying stocks have a certain value. When we add these individual values together, we arrive at the total asset value of the fund.
Dividing the total asset value by the number of units gives us the unit price or NAV. The NAV is reprised at the end of every day. This is because the asset value changes depending on the share prices of the underlying stocks.
For example, if mutual fund A owns one share of stock X and one share of stock Y, both of which are priced at $1 each, the NAV is $2. If the prices of X and Y rise to $2, the NAV is now $4.
Since prices keep fluctuating throughout the day, there’s no point in calculating the NAV in real-time. This is why it is done at the end of the day. During market hours, you can buy mutual fund units, but you’ll be purchasing them at the previous day’s NAV. There are a few things you must keep in mind when purchasing mutual fund units.
Their objective is to beat the market, and thus, the manager will charge fees that are higher than the other options listed in this module. On average, you can expect to pay between 0.5-2% of gains as fees. In addition to this, there are so-called “loading fees.”
A front-loading fee is one that is charged when you buy units. The fund manager will deduct a certain amount from your principal, and this will reduce your potential gains. A back-loading fee is charged when you redeem or sell your units. Some funds charge constant load fees, which is to say that they charge maintenance fees during the lifetime of your investment.
Keep in mind that a mutual fund can either charge all of these fees or some combination of them. Due to investors’ increased sensitivity to fees, some mutual funds offer no-load features and have you pay just the fee on whatever gains you make. Typically, no-load funds have higher performance fees.
The best way to get a handle on performance fees is to look at the expense ratio. This number is calculated by dividing the total cost of running the fund by the total assets. Keep in mind that expense ratios don’t always include loading fees.
One advantage of mutual funds is that if you choose to buy an in-house fund from your broker (a fund that is run by the brokerage itself) you’ll likely pay zero commissions on it. This will reduce your investment costs in the long run. Mutual funds don’t make the most sense these days as an investment.
Despite certain advantages, this is primarily due to the presence of the next option we’ll discuss. However, there are a few exceptional ones you can invest in. It’s just that finding them is tough.
Learn more about how mutual funds work.
Exchange-Traded Funds
ETFs were born from a need to reduce investment expenses. Mutual fund loading fees tend to reduce gains quite a bit. ETFs trade just like regular stocks does in the market. In other words, unlike with mutual funds, you’ll see their prices fluctuate up and down intraday.
In terms of structure, ETFs are built just like mutual funds are. They’re issued by large corporations and can have a number of investment objectives. In fact, compared to mutual funds, ETFs have a larger number of objectives.
For example, you can buy so-called inverse ETFs. These ETFs increase in price as market prices decline. You can buy an inverse ETF for a particular sector or the entire market. Then there are leveraged ETFs that move in a given direction faster than their underlying stocks. For example, if you buy a 2X leveraged broad market ETF, the ETF will rise at the twice speed of the underlying market. On the other hand, it will fall just as fast, so it’s not as if these aren’t without risk.
You will also find inverse leveraged ETFs, so as you can see, it’s possible to get quite complicated with these things. With that being said, you can invest in ETFs that aim to simply capture the average return of an index or a group of stocks. For example, you can buy an ETF that aims to capture the performance of a group of dividend-paying stocks.
ETFs have expense ratios as well, but the ones that aim to capture average market performance have lower expense ratios. These typically are under 1%, so they’re a lot cheaper to maintain than mutual funds, and this boosts your gains over the long term. When it comes to
ETFs it’s best to keep it simple and not opt for ones that have obscure investment strategies.
This is because many ETFs are created by investment banks to find people to take the other side of trades that hedge funds wish to take.
For example, if a hedge fund approaches their investment bank (their brokers) and wishes to create a portfolio that they wish to short (profit when the prices decrease). They need to borrow money from the bank to invest in this portfolio.
The bank then has to find someone else to take the other side of this trade. If they fail to find any institutional investors to take this bet, they often end up creating an ETF that contains the same underlying stocks and is leveraged.
Thus, you might end up buying this leveraged, long ETF while the hedge fund is on the other side of your trade. As prices decrease, you’re unlikely to be able to exit this investment since they’re not going to be heavily marketed, and thus, fewer people will be trading them.
You can buy ETFs that mimic hedge fund strategies, but you must conduct thorough research to see if these strategies are based on sound investment principles.
Mutual Fund vs. ETF: Key Differences
How They Are Traded
ETFs are bought and sold over exchanges, like stocks, at any time during the trading day. Mutual fund shares can only be bought from or sold to the mutual fund company, and only at that day’s closing price. On top of that, there are no minimum ETF purchases, as there are many mutual funds. But—and it’s a big but—every time you buy or sell shares in an ETF, you will incur brokerage fees, and that can cut deeply into your investing dollars.
Fees and Charges
Another difference is the fees and how they work. Sometimes you’ll fare better with an ETF, and other times you’ll have lower expenses with an index mutual fund. ETFs will often have lower expense ratios because they’re designed to incur minimal operating costs. That doesn’t mean they will always post lower expenses.
While the lowest-expense ETFs charge about 0.07 percent fees, there are plenty that charge much more. In fact, some charge as much as 0.50 percent, which is higher than the average index mutual fund charges.
As with mutual funds, though, you need to read through the ETF’s fund information to find out exactly what fees are charged to shareholders. And while many mutual funds come with no load (meaning no sales commission), ETFs must be bought through a broker, and that means a commission of some sort.
Income Tax Impact
Income tax impact is another big difference between ETFs and index funds. Because of the way they’re set up, ETFs don’t have the internal capital gains issues that index funds do. When index mutual funds rebalance their portfolios, investors get tagged with the capital gains resulting from the sale of holdings.
ETFs, on the other hand, use a different process to rebalance called “creation/redemption in kind,” which means that you won’t be hit with a tax bill as no security sale has occurred. Bottom line: ETFs create fewer taxable events than mutual funds, and that means you get to keep more of your money. (Of course, whichever type of investment you hold, when you sell your shares for a gain, you will be hit with the capital gains tax.)
Transparency
Transparency is another area where ETFs hold an advantage over mutual funds. Investors can always see exactly which stocks are being held by their ETF. This is in stark contrast to mutual funds, which are only required to report their holdings twice a year.
Why does this matter? Knowing exactly which securities your funds are holding makes it much easier for you to avoid fund (or portfolio) overlap, meaning you won’t be holding the same securities in two different funds (or in a fund and singly in your portfolio).
Mutual Fund vs. ETF: Key Similarities
Even though ETFs and mutual funds have some major differences, they do share a few similarities:
First and foremost, ETFs and MFs are similar in that they aren’t direct investments; they’re “conduits” of investing, which means that they act as a connection between the investor and the investments.
Both ETFs and MFs basically pool the money of investors and the pool becomes the “fund,” which in turn invests in a portfolio of investments.
Both ETFs and MFs offer the great advantage of diversification (although they accomplish it in different ways).
Investors don’t have any choice about what makes up the portfolio of either the ETF or the MF. The ETF has a fixed basket of securities (the money manager overseeing the portfolio makes those choices), and, of course, investors can’t control the choices made in a mutual fund.
For those investors who want more active assistance in making choices and running a portfolio, the MF may very well be the way to go. For those who are more comfortable making their own choices in terms of the particular index or industry/sector they want to invest in, the ETF may be a better venue.
Why Choose ETFs Over Mutual Funds?
Why would anyone buy an ETF matching an index when a mutual fund can beat the index? Managed mutual funds offer hit-or-miss performances. They do sometimes outperform their relevant index, but they also underperform; there’s no guarantee either way. On top of that, managed mutual funds usually charge hefty fees, and that always eats into profits.
ETFs are virtually the same as index mutual funds, but with some very important differences, the most important of which is that they trade like stocks on the secondary markets while mutual fund shares have to be bought from and redeemed with mutual fund companies. Other differences include trading choices, tax treatment, fees, and transparency.
Simply stated, in a mutual fund, securities such as stocks and bonds are constantly bought, sold, and held (in other words, the fund is actively managed).
An ETF holds similar securities, but the portfolio typically isn’t actively managed. Instead, an ETF usually holds a fixed basket of securities that may reflect an index or a particular industry or sector.
An index is a method of measuring the value of a segment of the general stock market. It’s a tool used by money managers and investors to compare the performance of a particular stock to a widely accepted standard.
For example, an ETF that tries to reflect the S&P 500 will attempt to hold a securities portfolio that mirrors the composition of the S&P 500 as closely as possible. Here’s another example: A water utilities ETF may hold the top 35 or 40 publicly held water companies.
Where ETFs are markedly different from MFs (and where they’re really advantageous, in my opinion) is that they can be bought and sold like stocks. In addition, you can do with ETFs what you can generally do with stocks (but can’t usually do with MFs): You can buy in share allotments, such as 1, 50, or 100 shares or more. MFs, on the other hand, are usually bought in dollar amounts, such as 1,000 or 5,000 dollars’ worth. The dollar amount you can initially invest is set by the manager of the individual mutual fund.
Here are some other advantages: You can put various buy/sell brokerage orders on ETFs, and many ETFs are optionable (meaning you may be able to buy/sell put and call options on them). MFs typically aren’t optionable.
In addition, many ETFs are marginal (meaning that you can borrow against them with some limitations in your brokerage account). MFs usually aren’t marginal (although it is possible if they’re within the confines of a stock brokerage account).
Sometimes an investor can readily see the great potential of a given industry or sector but is hard-pressed to get that single really good stock that can take advantage of the profit possibilities of that particular segment of the market.
The great thing about an ETF is that you can make that investment very easily, knowing that if you’re unsure about it, you can put in place strategies that protect you from the downside (such as stop-loss orders or trailing stops). That way you can sleep easier!
People Also Ask FAQs
Is it better to invest in the market through mutual funds or exchange-traded funds?
An ETF has intraday liquidity, which is what distinguishes it from mutual funds. If you are looking for the ability to trade like a stock, then an ETF is a better choice.
Do ETFs and mutual funds that invest in the same market and have the same passive strategy charge different fees?
In many cases, there is very little difference between fees. S&P 500 ETFs with expense ratios of 0.03%, for example, are some of the biggest and most popular. The Vanguard 500 Index Fund Admiral Shares (VFIAX) has an expense ratio of 0.04%, while the Vanguard 500 Index Fund (VOO) has an expense ratio of 0.03%.
Are currency risks hedged by ETFs investing overseas?
Currency risk is hedged by some ETFs investing in overseas markets.
Are index funds becoming more popular these days?
As mutual funds or exchange-traded funds, index funds track the performance of market indices. By the end of 2020, these two index fund categories will have a combined net asset value of $9.9 trillion8, up from just $1.9 trillion at the year-end of 2010. In 2020, index mutual funds and index ETFs combined to account for 40% of assets in long-term funds, double their share from a decade earlier.