Diversifying your investment portfolio is an important step in making sure you never lose too much in a market down turn and that is why comparing ETFs vs mutual funds will make it much easier for you to implement a diversification strategy.
Mutual funds and ETFs are very similar investment types. Their similarities make it really difficult for people to understand which one is best for their needs.
This guide aims to get you as clear as possible on each one, and help you to work out which is the right one for you. If you’re looking to invest some money, read on to discover where it’s best going to so you can enjoy the highest rate of return and the most benefits from your choice.
What is a Mutual Fund?
A mutual fund is a managed portfolio of stocks, bonds, or both in some cases. A mutual fund is where a company that brings together a large group of people manages the investments made, and collectively invests the investor’s money into a portfolio on their behalf. Each investor holds a share of the mutual fund.
In short: it is a pool of money belonging to a large group of people who want to save or make more money. It could potentially be a smart investment to make for any investor, which is why it’s worth knowing about whatever stage of your investment journey you’re at.
To put it as simply as possible: mutual funds are like baskets. Each basket holds certain types of stocks and other investments. It’s important to remember that each investor owns shares of the mutual funds but not the holdings. Investing in a share of mutual funds is different to investing in shares of stock. Mutual fund shares don’t give investors any voting rights in a company.
An investor may earn a return from a mutual fund in a number of ways, including income earned on stocks and interest on bonds that are in the portfolio. There are a number of pros and cons to mutual funds, which we’ll talk about a little later on.
Basic Mutual Fund Types And Categories
Stock funds and bond funds are two of the most popular types of mutual funds. You then get three sub-categories of capitalization — small-cap, mid-cap, and large-cap. These can be categorized further as either growth, value, or growth and income. Stocks can also be classified as international, global or foreign, however, they all similar objectives to one another.
It’s worth knowing the exact type of mutual fund you are looking at, as things can change depending on the various factors.
The Benefits Of Mutual Funds
Although there are different types of mutual funds, let’s talk a little more about the general benefits of them.
- Professional Management – your mutual fund investment is professionally managed by a skilled person with experienced. You do not have to pick stocks and manage your investment yourself. An investment manager takes care of all of this using their specialist trading skills. This means you can free up time to do other things, without having to worry about your investments. You will have more time and less stress. If you choose the right company, you may have more money too.
- Diversification – you get diversification when you select a mutual fund. Your risk is spread out across many different holdings in this type of investment. Large mutual funds typically own hundreds of different stocks in different industries. If you know anything about investing, you’ll know how important diversification is for success. The majority of investors will tell you not to put all your eggs in one basket, and with a mutual fund, you’re automatically diversifying.
- Simplicity – with a mutual fund, you get simplicity. The process is fairly straightforward, and the initial investment can usually be quite small. Most people do not have the knowledge and experience required when first starting out, or even the big bucks to invest. If you’re feeling lost and want something easy, a mutual fund could be the way you begin your investment portfolio.
- Transparency – Some people worry about working with vague companies and not knowing where their money is really going. Accountability and fairness to investors is ensured thanks to industry regulation. You won’t need to worry about anything going awry with your mutual funds without you knowing about it first.
- Ease of Use – this process can be much easier than investing in stocks and bonds on your own. Even if you know what you’re doing, a mutual fund could free up more time for you.
- Low Initial Investment – you can get started with as little as $100 for most mutual funds. If you pledge to invest $100 a month, you will usually be better off as there are less fees to contend with.
Disadvantages of Mutual Funds
As beneficial as mutual funds can be, there are some disadvantages you will want to think about too. Take a look at them below:
- Active Management – Although investing in mutual funds can be attractive thanks to the managed investment portfolio, some investors debate whether the managers are better than the average investor at selecting stocks. Even if the fund loses money, the manager still gets paid, so it doesn’t matter to them too much how well they handle it. Some people believe that they could do a similar job, if not a better job, depending on who is managing the mutual fund. There’s no guarantee that the person managing your fund will be a total expert and get you the best results.
- Costs and fees – creating and running a mutual fund can be expensive. Fees can vary from fund to fund. All of the money you spend on fees is money you have not invested to grow over time. If you were to go for a more cost effective fund, you would also have more money to invest, and earn a higher rate of return in the long run.
- Dilution – you could potentially get poor returns due to too much diversification. This can also result from a successful fund that has grown too big. While diversification is important, dilution is the last thing you want to happen. Most don’t realize that dilution is a problem.
Best Places To Invest In Mutual Funds
Most investors will have some kind of mutual fund in their portfolio. If this is something you’re looking to add to yours, there are a few places you should look at first.
The following places offer high quality selection, affordability, service, and tools to help your mutual fund investment prosper. Some of the best companies include:
- Ally Invest – Ally bank recently bought out TradeKing and converted them to Ally Invest. This is the best place for beginners because they do not require a minimum amount to get started. Any mutual fund that has a load requires zero transaction fees and no load mutual funds are only $9.95 per trade.
- Vanguard – I have one of our Roth IRA’s in Vanguard and they offer all their funds for no fees. The only reason I do not suggest them for everyone is that many of their funds require s $3,000 investment to get started. I know several people who have started with an Ally account and then rolled that money over to Vanguard once they had enough.
Pretty much any brokerage will allow you to invest in mutual funds, so remember to look into each individual company carefully before you decide who should handle your mutual fund investment.
What is an ETF?
The abbreviation ETF is short for ‘Exchange Traded Fund’. Although it is very similar to a mutual fund, there are some notable differences.
The main difference is that an ETF is a marketable security that tracks an index, a commodity, bonds, or a basket of assets similar to an index fund.
Just like when you buy a share of stock, ETFs experience price changes throughout the day as they are bought and sold. They have higher liquidity, and make an attractive alternative for individual investors who do not want to invest the larger sums it takes to buy into a mutual fund.
An investor may get residual value in case the fund is liquidated, and ETF shareholders are entitled to a proportion of the profits, such as earned interest or dividends paid. ETF shares are traded on public stock exchanges. Let’s take a closer look at the benefits and some of the disadvantages of an ETF.
Benefits Of ETFs
ETFs have many benefits that you’ll want to consider.
- Trading Flexibility – You get trading flexibility when you choose an ETF. ETFs are bought and sold during the day when the markets are open, and pricing is continuous through normal trading hours.
- Diversification and Risk Management – ETFs provide an investor easy access to a desired market segment, which is easier for investors who may not have expertise in those areas.
- Lower Costs – operating costs come with all managed funds, but you can expect them to be significantly lower with an ETF. Marketing expenses, custody costs, and more are all things you will need to think about with most funds. Costs can be more streamlined with ETFs, however. You will get lower expenses in the case of monthly statements, tax reports, quarterly reports, and more.
- Tax Benefits – mutual funds typically incur more capital gains tax than ETFs due to differences in structure. The tax benefits are one of the most attractive benefits of ETFs.
- One Transaction – you can usually purchase an ETF with one easy transaction. It has a simple structure and is fairly easy to understand, so it is very useful for beginners. However, any level of investor can put their money into an ETF.
- Accountability – the company sponsor, designer, and creator of the ETF publishes a list of assets in the fund on a daily basis. This means you know exactly what is going on with your ETF. These are investments that are known for their transparency.
- Passive Management – minor adjustments are needed for an ETF, as opposed to other funds that are aggressively managed. This is how the risk and management fees are lowered.
- Immediate Dividends – with ETFs, dividends can be immediately invested back into the funds.
Disadvantages Of ETFs
There are many advantages to an ETF, but you can’t ignore the disadvantages if you want to make a well informed decision.
- International Limitations – There are some international limitations with an ETF. The US has many ETF products for investors to look at, however, some countries only have a handful.
- Low Trading Volumes – when ETFs have low trading volumes, the other advantages diminish. Bid ask can be spread too wide to be cost effective in some cases.
- Inactivity – some ETFs aren’t traded as actively as others. This can be due to sector or regional issues.
- Tax Implications – tax laws vary from country to country, so this is worth bearing in mind if you are looking to invest in foreign ETFs.
Best Places To Invest In ETFs
Knowing the best places to invest in ETFs is crucial if you want the best place for your money.
The following places offer high quality selection, cost effectiveness, great customer service, and tools to help your ETF give you the highest return. Two of the major providers of ETFs are:
- Betterment – Betterment is the best way to invest in ETFs for new investors or for people who want a hands off approach to investing. Instead of having to pick ETFs yourself, Betterment gives you a shot questionnaire to gauge your risk tolerance and then does all the investing for you. In my review of Betterment we discuss how they use ETFs to make all the investments.
- TD Ameritrade – If you are going to pick ETFs for yourself then TD Ameritrade is the best option. They offer over 100 different ETFs that you can purchase for no trading fee. They are, by far, the best at offering no fee trading for ETFs.
Mutual Funds vs ETFs – The Real Differences
So, with all of this in mind, what is the real difference between mutual funds and ETFs? They are similar as both instruments bundle together anywhere from 100-3000 securities to offer investors a diversified portfolio.
However, ETFs trade throughout the trading day, like stocks, while mutual funds trade only at the end of the day at the net asset value (NAV) price.
ETFs offer lower operating expenses more than mutual funds as they usually track to a particular index, this savings can mean you may get a better rate of return in the long run. ETFs have no investment minimums either. Take a look at the differences in a nutshell below:
- Trade at closing NAV price
- Operating expenses will vary
- Have investment minimums
- Are less tax efficient
- May have sales load
- Trade during daily trading
- Have low operating expenses
- No investment minimums
- More tax efficient
- No sales loads
Both Mutual Funds and ETFs have a place in a varied investment portfolio. However, while a mutual fund is still a solid choice, ETFs are something you should definitely incorporate for maximum benefit and returns on your investments.
That being said, it’s so important to do your own research on any financial asset before making either long or short trades. Just because an ETF has many benefits, does not mean it will be the right choice for you.
If you have any questions, feel free to leave them in the comments.