When comparing mutual funds and exchange traded funds (ETFs), there are several key similarities and differences investors should know before buying. But which is best for you--mutual funds or ETFs? Since each of these two investment security types has its advantages and disadvantages, some investors may choose to include both in their portfolios.
Mutual Funds and ETFs: Key Similarities and Differences
Mutual funds and ETFs are two distinct investment securities, but they share the same basic structure and functionality. Both types of funds are diversified investments, meaning you can get exposure to dozens or hundreds of stocks or bonds (or both) in just one fund. Since most ETFs passively track an underlying index, they are most similar to index mutual funds. (Index ETFs account for approximately 80% of ETF funds).
Overview and the Pros and Cons of Mutual Funds
The key differences between mutual funds and ETFs are in how they trade and their costs. Mutual funds are bought and sold at net asset value (NAV) and only at the end of the trading day. However, like stocks, ETFs are bought and sold at a market price and can be traded intraday. ETFs also typically have lower initial costs and lower expense ratios than mutual funds.
Mutual funds are pooled investments that allow investors to buy a collection of securities, such as stocks or bonds, in one collective basket. Most mutual funds hold dozens or hundreds of stocks or bonds (or both) in just one fund. However, like other investment types, mutual funds have their pros and cons.
For example, the Vanguard 500 Index (VFIAX) invests in about 500 of the largest U.S. stocks, as measured by market capitalization. The Vanguard Total Bond Market Index (VBTLX), which invests in the total U.S. bond market, includes more than 5,000 domestic bonds. Vanguard Balanced Index (VBIAX) is essentially a blend of VFIAX and VBTLX, with approximately 60% of assets in large U.S. stocks and 40% of assets in U.S. bonds.
Pros of Mutual Funds
- Diversification: Mutual funds are diversified investments because investors can get exposure to a number of securities in just one fund. Diversification can reduce volatility by spreading risk among many different stocks or bonds, as opposed to just one single security.
- Active management: Mutual funds can be either passively managed or actively managed. For investors who do not want to passively invest in an index fund or an ETF that tracks an index, active management is a way to get professional management, and potentially outperform an index, for a relatively low cost.
- Accessibility: Mutual funds are easy to understand and readily available for purchase at a variety of mutual fund companies, brokerage firms, online discount brokers, and retirement accounts. For this reason, they are the investment of choice for individual retirement accounts (IRAs) and 401(k) plans.
Cons of Mutual Funds
- Investment costs: Most mutual funds have minimum initial investment costs of $1,000 or higher. If bought through a broker or other type of commission-based advisor, mutual funds may have sales charges, called loads, that can be up to 5% or more of the purchase (front load) or the sale (back load) of shares. Typical mutual fund expense ratios are 1.00% or higher. To keep expenses to a minimum, investors should use low-cost, no-load mutual funds.
- Limited trading flexibility: Mutual funds trade at NAV at the close of the trading day. This can be a disadvantage for investors who want to take advantage of sudden price trends. For example, if the market has positive momentum, the investor may want to get ahead of the trend and buy early in the trading day. Or, if the price trend is down, the investor may want to sell during the day to minimize losses.
Overview and the Pros and Cons of ETFs
ETFs are investment securities similar to index mutual funds in that they passively track an index (such as the S&P 500, the NASDAQ 100, or the Russell 2000). Unlike mutual funds, ETFs trade like stocks on a stock exchange. Before investing, it’s important to be aware of the pros and cons of ETFs.
Pros of ETFs
- Diversification: Like mutual funds, ETFs are diversified investments because they can provide exposure to dozens or hundreds of securities, such as stocks or bonds, with the purchase of just one fund. Diversification can reduce volatility by spreading the market risk across multiple securities or asset types rather than just one. For example, Vanguard Total Stock Market ETF (VTI) invests in over 3,500 U.S. stocks. This covers stocks of companies in all sectors of the U.S. economy.
- Low cost: ETFs are known for their low expense ratios, which typically range between 0.10% and 0.25%. Because ETFs are passively managed, the operating costs are dramatically reduced because there is no need for research or analysis, as is needed with actively managed mutual funds.
- Trading flexibility: Since ETFs trade like stocks, shares can be bought or sold during the day. This flexibility enables investors to place market orders, such as a stop-loss order, which can be set by the investor to sell out of the ETF at a certain price, usually to minimize losses.
- Niche trading: ETFs can be used to get access to niche areas of the market that are not typically covered by mutual funds. For example, ETFs may not only cover sectors, such as technology, but they may cover narrow sub-sectors, such as artificial intelligence and robotics.
Cons of ETFs
- Trading costs: Since ETFs trade like stocks, investors may be required to pay a commission, which can range between $10 and $20 per trade. While some ETFs can be bought and sold free of commission, trading costs can be high if the investor makes frequent trades. Even if the investor only makes monthly purchases, as in a dollar-cost averaging strategy, small commissions can add up to make ETFs an expensive investment compared to a no-load, no transaction-fee mutual fund.
- Market risk: Because many ETFs specialize in one concentrated area of the market, these funds may have greater price fluctuation compared to a broader stock index, such as the S&P 500.
Which Is Best for You: Mutual Funds or ETFs?
Mutual funds and ETFs can both be effectively used by almost any investor. Mutual funds are most commonly used by beginning investors and long-term investors and are the primary investment type for 401(k) plans. ETFs are most commonly used by short-term traders or investors who want to buy into niche areas of the market.
Some investors like to use a combination of mutual funds and ETFs to build a diversified portfolio. They may prefer to use mutual funds for active management and ETFs for tracking certain benchmark indexes. No matter which type of funds you use, be sure to build a portfolio that is suitable for your investment goals and risk tolerance.
