Do you know the difference between an ETF and a mutual fund? When it comes to investing, there are many options for what type of investment to invest in. Your options include:
- Mutual Funds
- Alternative Investments
Most investors are familiar with the first three on that list. ETFs have become more popular in recent years. Many times, people question what the difference is between an ETF and a mutual fund. I am going to break down each investment product here so that it is clear to you. Note that I will focus more heavily on ETFs since most investors don’t fully understand how they work.
What is an ETF?
An ETF or Exchange Traded Fund is very similar to a mutual fund in that an ETF holds a basket of underlying stocks or bonds and typically tracks an index. ETFs first appeared way back in the late 1980’s. But their life was short lived due to various court battles. It wasn’t until the mid 1990’s when ETFs truly began to gain in popularity.
At the beginning, ETFs were mainly a passive investment, meaning they simply tracked an index. However, in 2008, the Securities and Exchange Commission allowed for the introduction of actively managed ETFs.
What is a Mutual Fund?
A mutual fund also holds a basket of underlying stocks or bonds. A mutual fund uses an index as its benchmark to compare its performance against. Mutual funds have been around since the late 1890’s, but didn’t take off in popularity until the 1970’s.
Primarily there are two types of mutual funds: open end and closed end mutual funds. Open end funds allow unlimited shares to be created for investors while closed end funds limit the number of shares available to invest in.
What Are The Differences Between ETFs and Mutual Funds?
The main difference between an ETF and a mutual is this: you can trade an ETF throughout the day. With a mutual fund, any trade you place during the day doesn’t get executed until the market closes and the NAV of the mutual fund is calculated. (Quick side note: the NAV or net asset value is simply the price of the mutual fund after all liabilities of the mutual fund are subtracted from the assets. The NAV is calculated at the close of business.) Whatever price the mutual fund closed at is the price you get for you buy or sell, regardless of the time you placed the trade.
For example, let’s say I placed an order to sell my mutual fund at 10am. My sell is executed at the 4pm closing price of the mutual fund. This can work for or against an investor. It works in favor of the investor should you be selling on a day when the market is up. If the market closes at its peak for the day, you take advantage of that. However, if the market is dropping, you can’t sell until the market closes.
With that said, say you decide to sell you mutual fund at 6pm. What happens then? In this case, you would get the closing price for the next business day. Same thing holds true if you were to place a trade on the weekend as well.
With an ETF on the other hand, if you sell at a time when the market is open, you will sell at that time. Taking the example above, if I place a sell at 10am for my ETF, I will sell the ETF at the 10am price. If I place a trade after hours, I will get the price once the market opens on the next business day.
ETFs also allow you to place stop and limit orders as well. With mutual funds, you don’t have this luxury.
ETF Advantages and Disadvantages
So why are ETFs so popular? First is because of the ability to trade the ETF throughout the day. The second benefit is low expenses. Most ETFs have a lower expense ratio than mutual funds. This is a big reason for the popularity of ETFs.
Of course, there are some downsides to ETFs as well. First off, most brokers charge a commission to trade an ETF much like a stock. Every time you place an order for an ETF, expect to pay a commission ranging from $6 on up. With that said, there are some brokers that waive the fee for trading their own house brand of ETF. Schwab is a perfect example of this. You can buy and sell Schwab ETFs for no commission. They also allow for you to trade a few other ETFs for no fee as well.
Another drawback of an ETF is that much like with stocks, you have to buy round numbers. With a mutual fund, you can invest $500 and buy fractional shares, such as 12.4956. With ETFs, you can only buy whole shares. Using the $500, you could only buy 12 shares. This, along with the fee for trading ETFs makes them more costly than mutual funds.
A final drawback that some people make regarding ETFs is that they encourage you to trade. Some people claim that Wall Street invented ETFs so that they could have another way to earn a fee. Add this to the fact that you now have the ability to act on your emotions and buy or sell at any point during the trading day hurts investors. I’m not 100% certain I buy into this logic, but I can see the argument.
There are certainly benefits to investing in ETFs, most notably the lower expenses. If you are disciplined enough to not act on emotion and stay invested for the long term, the ability to trade ETFs is not an issue. When it comes to trading commissions, you have two options: either pay the fee or invest in ETFs with brokers that don’t charge the fee. This is what I do with Schwab.
I still own mutual funds as well, since I am at a point where I still invest a small amount of money each month. Overall, both mutual funds and ETFs have benefits and drawbacks. I find that using them both in a diversified portfolio is a good compromise.
Do you invest in ETFs or mutual funds?