Back

Mutual funds vs ETFs

Lesson in Course: ETFs and mutual funds (beginner, 5min)

Mutual funds and ETFs are two very common investments. What is the difference and how do we know which one to go with?

Eureka!

What it's about: Mutual funds and ETFs are professionally managed portfolios.

Why it's important: They provide easy and low cost diversification for us.

Key takeaway: We can become successful investors by simply buying a couple mutual funds and/or ETFs.

Mutual funds and ETFs serve as great passive investment options for our portfolio.

What is Mutual funds?

Portfolios of investments that are built and managed by investment professionals.

The key difference is that mutual funds don't necessarily follow an index.

What is ETFs?

Portfolios of investments created to follow or track different indices.

For example, an S&P 500 ETF will have all of the shares in the proportions that make up the S&P 500 index. If the S&P 500 is up 1%, the ETF will also be up 1%.

Similarities

Mutual funds and ETFs have a lot of similarities

Professional management

ETFs and mutual funds are both professionally managed investment funds that pool the money from many investors to create a portfolio. Each investor gets a share of the portfolio. Depending on the fund's strategy, there could be a wide variety of investments in the portfolio. 

When we find a strategy we like, we can buy a share of the fund and rely on the professionals to monitor it daily on our behalf.

Fee structure

The managed services don't come free. Both products charge management fees based on the fund's assets under management (AUM). 

What is Assets under management ?

The total market value of the investments in a fund's portfolio

The fund uses these fees to keep the lights on and pay employees. The fees are stated by the expense ratio.

What is Expense ratio?

A percentage of the AUM that a fund charges as a management fee

If a fund has an expense ratio of 0.5%, it will charge $5 annually for $1,000 invested in the fund. When we buy an ETF or mutual fund in our brokerage account, don't expect a bill for these fees. Instead, the fees will be deducted from the value of our investments.

Accessibility

ETFs and mutual funds are easy investments to make. We can purchase them through our brokerage once we find one that matches a strategy we want.

ETF and Mutual funds are easy to purchase

These products give us access to investments we might not have otherwise been able to make. For instance, some stock prices are more than an average person could afford. By pooling money from investors, the fund can buy the expensive investments for the portfolio. That way, we own a fraction of that investment when we buy a share of the fund.

Roommates splitting the rent of a house is a similar example. Individually they might not be able to afford the entire rent, and depending on the room size, the rent might be higher or lower.

Less accessible funds

Hedge funds, private equity funds, and venture capital funds are pooled investment vehicles too. However, they have particular requirements. They often require investors to make a minimum investment amount and have a certain amount of "sophistication." They also have a redemption period, meaning the money is locked up and can't be withdrawn over a specific amount of time.

Diversification

Both fund types offer great diversification benefits by allowing us to invest in a broad pool of securities without having to buy them all ourselves.

Defined objective

Every fund has a mandate that specifies its investment focus, which can be either passively or actively managed.

Passively managed funds usually invest in securities that replicate a market index, belong to a similar business sector or industry, or fall within a range of market capitalizations (business sizes).

Actively managed funds have more flexibility in the securities they invest in and the strategy they pursue to maximize returns. Some investors with a passive investment strategy will include actively managed funds in their portfolios.

Variety

No matter our investment goals, there is probably a fund that fits what we are looking for regardless of how broad or specialized it may be.

With so many options, investors can build a great portfolio with just a few different broad-based funds.

Differences

There are three factors used to differentiate ETFs from mutual funds

Liquidity

The primary difference between these two fund structures is liquidity, which is when you can invest (or withdraw) your money. Mutual funds typically allow investors to buy and sell their shares at the end of each business day, whereas ETFs are open for trading anytime during market hours. We can buy one share of an ETF at 10 am and sell it an hour later if we want.

Pricing

Share prices for ETFs and mutual funds are also known as the net asset value (NAV).

What is Net asset value ?

The price of a fund's shares -- determined by dividing the market value of the fund's assets by the number of shares in the fund

Mutual funds price their shares at the end of the day after the financial markets close. So if we sold our shares during the day, we wouldn't know the exact amount we'd get for them until the end of the day. 

On the other hand, the NAV of an ETF is typically quoted throughout the day, making it easy to determine the price of each share at a given moment. However, ETF shares can sometimes trade at premiums or discounts (usually small) to the fund's NAV because of fluctuations in supply and demand.

 

Expense ratios

ETFs generally offer lower expense ratios because it's cheaper to replicate an index than to create the custom strategies provided by mutual funds. For two very similar strategies, the ETF is better because of lower fees.

 

Actionable ideas

ETFs can provide diversification and more liquidity if you're looking for flexibility in the timing of buying or selling investments. Whereas, mutual funds often offer custom strategies that ETFs don't.

For both fund types, the expense ratio is a key metric to evaluate before making an investment decision. A lower expense ratio means that, over time, you keep more money. Funds with higher expenses need to consistently outperform their lower-cost peers, all else equal – something that has been very hard to achieve in the history of financial markets.

Both fund types are great ways for you to achieve low-cost diversification.

 

Supplementary materials

Check out this short video comparing ETFs and mutual funds
https://www.youtube.com/watch?v=Es3vXJ7GoV8&ab_channel=WallStreetJournal

Glossary

What is Assets under management ?

The total market value of the investments in a fund's portfolio

What is Expense ratio?

A percentage of the AUM that a fund charges as a management fee

What is Net asset value ?

The price of a fund's shares -- determined by dividing the market value of the fund's assets by the number of shares in the fund