Mutual funds and ETFs (exchange-traded funds) are considered securities and have many similarities, but they are not the same thing. Both present options to consolidate a group of publicly traded companies into one fund. One of the main benefits of consolidating your investments into one package is that it’s a quick and easy way to diversify your portfolio. Below, we will cover the main differences between ETFs and mutual funds.
ETF and Mutual Fund Differences
One of the main differences between the two funds is that an ETF is tradable like a stock. You can buy and sell an ETF at any time during the day’s trading session. But most mutual funds can only be purchased at the end of the day for a specific price.
A mutual fund is also actively managed, meaning that there is a fund manager that dynamically chooses how to allocate the money in the fund. Exchange-traded funds, on the other hand, are passively managed and are usually tied to a particular market index.
For example, if you invest in the SPDR S&P 500 ETF, ticker symbol SPY, you can invest in an index that tracks the S&P 500 as a whole. Investing in an ETF such as this allows you to invest in a small piece of every S&P 500 company simultaneously.
A fund manager typically selects the stocks and investments that make up a mutual fund. For most people, it feels safer having an expert select stocks to invest in rather than trying to go at it on your own. Even if you are confident in your abilities and instincts to pick out stocks and know when to buy and sell, you likely do not have the time or the expertise that the fund manager does.
When it comes to picking a mutual fund, you have a plethora of options. Some standard options you will come across are large-cap, medium-cap, and small-cap funds. The “cap” is short for the market capitalization of the companies in the fund. Market capitalization refers to the dollar amount of the company’s total outstanding shares. It reflects the company’s share price multiplied by the number of shares that have been purchased.
Legally, mutual funds are classified in two ways: open-end and closed-end funds.
A closed-ended fund operates similarly to an ETF in that it can be traded throughout the day on a stock exchange. The “closed” aspect is that there is a set amount of shares, and new shares are not issued even if demand grows. The significant difference between an ETF and a closed-ended fund (CEF) is that an ETF is passively managed, while a CEF is actively managed.
Open-end funds (OEF) are what people typically think of when talking about mutual funds, as there are vastly more OEFs than CEFs. An open-ended fund will issue new shares whenever demand increases, and the sale of shares takes place between the investor and the fund company. The number of outstanding shares does not affect the value of an individual share, so the number of shares that can be issued is limitless. At the end of each day, a net asset value (NAV) is determined by the total net value of the fund’s investments. At that time, new shares can be bought and sold.
Like a mutual fund, an exchange-traded fund is a security that encompasses a collection of securities. Unlike mutual funds, ETFs have no minimum amount to invest. If you would like, you can buy just a single share of an ETF.
The price of an ETF will fluctuate throughout the day, as shares are bought and sold on an exchange. Overall, the value of an ETF is meant to be directly tied to an index. If you own shares of an ETF that track the NASDAQ and the NASDAQ goes up as a whole, the value of your shares increases along with it.
Investing in an ETF allows you to get a piece of much bigger companies such as Amazon, Apple, and Alphabet without having to fork over the massive individual share prices of each company.
Bottom Line on ETF vs. Mutual Fund
Mutual funds and ETFs are both securities that encompass a collection of smaller securities. Because an ETF will track an index, it does not need to be actively managed like a mutual fund.
The idea behind investing in a mutual fund is that you have a fund manager or a team of fund managers that actively look to buy and sell securities to beat the market. When you invest in an ETF, you are effectively investing in the market as a whole, depending on which sector you want to target.
Both mutual funds and ETFs can include stocks, bonds, and commodities. Due to the broad investment portfolios offered by both types of funds, investing in either a mutual fund or an ETF is an excellent way to diversify your portfolio. By investing in one or many funds, you can mitigate your risk while setting yourself up for long term investing success.
On the contrary, if you invest in select companies, there are any number of different outcomes that could happen. The stock could double in price, and you look like a genius, or it can drop drastically in value, leaving you with pennies per dollar invested.
When you invest in a mutual fund, you are handing the keys of part of your portfolio to an expert. When you invest in an ETF, you are investing in an entire sector of stocks.
Mutual funds come with more fees and higher minimum investments than ETFs because there is a team actively managing the fund. Ideally, that team is helping the fund to outperform the market, meaning your investments are worth more than if you invested in the market as a whole.
The bottom line on both funds is that they provide a way to mitigate your risk and set you up for steadily increasing profits in your portfolio.