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January 19

The Differences Between ETFs and Mutual Funds Explained

by Luca Yates

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If you are looking to invest, you will likely come across two major types of investment funds: exchange-traded funds and mutual funds. Both of these investment options pool investor money and allow investors to diversify their portfolios without having to buy each of the individual assets in the fund one by one. Exchange-traded funds (EFTs) have become very popular mainly because a lot of investment advisors tell their customers to include them in their portfolios. Mutual funds remain popular due to the diversification benefits they offer investors. There are other similarities and differences between ETFs and mutual funds, and it is these differences we are going to look at so you can decide which of the two is the better option for you.

Management

A key difference between ETFs and mutual funds is the way they are managed. Mutual funds are usually managed by a professional manager who tries to beat the market by selling and buying funds. Because this type of management is active and requires a manager, it often means that mutual funds end up costing more for investors. 

ETFs do not usually require human management as they are usually passively managed. ETFs are set up to track a specific index. If you want a hands-on manager, you can get one for your ETFs but at that point, they will be functioning like mutual funds and will attract higher fees because they will be actively managed.

Actively managed funds have been shown to outperform passively managed ones in the short-term but tend to fall behind in the long-term. This is because actively managed funds need to keep beating the market all the time, which does not always happen and this, coupled with the high expenses, means that actively managed mutual funds have lower returns in the long-term than passively managed ETFs.

Expenses

The amount you pay each year to own a fund is known as the expense ratio. Because of the reasons we have looked at above, passively managed ETFs have lower expense ratios, which can be as low as 0.03% of the amount they invest. So, if you invest in an ETF with this ratio, you will pay $0.30 yearly for every $1,000 you invest. 

Actively managed mutual funds, on the other hand, will usually have a higher expense ratio. 

One thing to note is that ETFs are not always the cheapest option available because there are great mutual funds that have an acceptable expense ratio. This is why it is important to always compare specific ETFs and mutual funds when looking for an investment option to see which of the options available would work well for you.

If you are eager to start investing in ETFs while keeping your expense ratio very low, it might be the right time to join an automated trading service such as Wealthsimple. Wealthsimple offers state-of-the-art investment and trading technology and low fees whether you are investing in an ETF or a mutual fund. They also have friendly staff who will answer any questions you might have about an equity fund vs mutual fund. Their automated trading solutions are easy to understand and you can start investing in minutes.

Choice of investments

Mutual funds, by nature of being actively managed have an expert or team of experts behind them. These experts choose the best investments and the best place to put your money. The fund managers have guidelines and parameters that guide them on the types of investments hay can make. The performance of your investment relies heavily on the types of investment choices your manager makes.

ETFs do not usually allow for any flexibility in the types of investments that are made. This means that the index they are tracking goes down, so does your investment.

Actively managed mutual funds give investors the option of exiting bad holdings to avoid huge losses in case of a market downturn. While this does not always work, it is an advantage worth exploring. It is also the reason why you will see a lot of investment experts start advising people to switch to active management once the market starts to turn.

Trading

ETFs are traded throughout the day much like shares and their prices are based on supply and demand. Traditional mutual funds are traded at the end of the day. Mutual funds are bought and sold at what is known as the net asset value that is determined by the assets in that specific mutual fund and their value at the end of the trading day. 

Although they can be traded throughout the day, ETFs are not meant to be used as a tool for day trading. This is why many brokerage firms require that you hold your ETF for a specific period before selling it. 

Also, because ETFs can be traded similarly to stocks, they attract a commission with each trade. Many brokerage firms are doing away with these commissions as they make things very complicated for them if there are ETFs that are being traded rapidly and to attract investors who would not like to keep paying commissions on every ETF they buy or sell. 

Niche Trading Options

Mutual funds are more traditional than ETFs, and this is why they do not convert some of the niche industries and market segments that some ETFs do. For example, a mutual fund can cover technology, but an ETF can go further to cover sub-sectors such as robotics and artificial intelligence.

Investment Costs

Mutual funds have a high cost of entry. Which is usually at least $1,000. In contrast, you can buy one share of an ETF which will be a lot cheaper than buying a mutual fund. Because of this, ETFs make it easier to enter into a position or add to one you already hold.

Taxation

As mutual funds are sold throughout a year, all profits generated from these sales are passed on to all shareholders who are invested in that mutual fund. These profits are called capital gains distributions. If you do not know how they work, they might come as a surprise to you, especially when it comes to taxation.

If you hold your mutual funds in an account that attracts taxes, you will be taxed for the gains made each year. However, if you hold your mutual funds in a tax-advantaged account such as an individual retirement fund, you do not have to worry about taxation. This is because, instead of paying taxes on your capital gains for each year they are distributed, you only pay taxes once you withdraw the money after retirement.

These taxes are not a big deal for long-term investors such as those holding their mutual funds in their retirement accounts. They are a headache for short-term investors who might want to reinvest their capital gains.

Reporting

One of the biggest advantages of investing in an ETF over a mutual fund is that you can view your ETFs holdings online at any time. On the other hand, most mutual funds only disclose their holdings once a year. 

Transparency in how your holdings are doing is important for most investors. However, some investors might not care too much about how their ETF is doing day to day.

Which Is Better for You: Mutual Funds or ETFs?

Mutual funds and ETFs are both excellent investment options for a log of investors. However, their differences plus the different benefits they can afford you are what will determine which of the two to choose. If you are a beginner or a long-term investor, managed mutual funds would be the better option for you. You just have to remember that managed mutual funds will cost you more per year.

ETFs are a great option if you are a short-term trader and are looking to invest in niche markets. ETFs will allow you to invest in sub-sectors that mutual funds will because most mutual funds focus on whole sectors.

If you want a diversified portfolio, a mix of mutual funds and ETFs might be the better option for you. Although both of these investment options are already diversified enough by themselves, their mix of investment options is great to have for further diversification.

A mix of both allows you to take advantage of the active management that you get with mutual funds with the ability to track specific indexes that are offered by ETFs.

Although there are lots of investment options available to you, mutual funds and equity-traded funds (ETFs) remain a popular option for a lot of investors. This is because they are pools of money where investors buy shares while offering a diversification of your investment portfolio. Both of these investment options come with certain risks and this is why it is so important to choose the type of fund that is suitable for our investment goal and whose tolerance you can accept. In addition to the differences above, you can also talk to a financial or investment advisor to help you choose the best mutual fund or ETF that would work best for you.

The Differences Between ETFs and Mutual Funds Explained

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About the Author 

Luca Yates

Through his work in the SEO and Corporate landscapes, Luca Yates has been on his own personal growth journey. Today, he loves helping others to achieve their goals.