What’s the difference between ETFs vs. mutual funds? Learn how some investors choose ETFs and mutual funds to pursue portfolio diversification.
If you’re like many investors saving for retirement or another goal, you’ve heard about portfolio diversification. “Don’t put all your eggs in one basket” is among the most common pieces of wisdom dispensed to investors.
Two typical avenues investors might use for diversification are mutual funds and exchange-traded funds (ETFs). When comparing ETFs and mutual funds, it’s important to note that ETFs and mutual funds are similar in that both represent a professionally managed or index-based “basket” of securities, typically stocks and bonds. Yet, they’re structured differently.
Years ago, the key difference between mutual funds and ETFs seemed simple. Most, though not all, ETFs featured a “passive” management approach, and most, though not all, mutual funds featured an “active” management approach. Since then, things have changed. Today, index-based mutual funds are common, while ETFs have expanded and grown to include some very complex, exotic, and risky products. The expense ratios respective to both instruments may also vary; and the features and functionalities that make either instrument a good match for an individual investor is contingent on the investor’s financial goals, resources, and individual investing preferences.
For investors trying to decide whether mutual funds or ETFs are the right choice, it helps to delve a bit deeper in how they compare and contrast. First, let’s look at the landscape, which has changed dramatically over the last 25 years.
An ETF is a single security that typically tracks an index or portfolio and seeks to target their performance. First introduced in 1993, ETFs have become more popular with investors who are looking to minimize costs while maximizing tax efficiency and investment visibility within their portfolios.
As of fall 2021, Bloomberg reported that there were some 2,500 ETFs compared with around 6,300 mutual funds but noted that from 2020 to August 2021, ETFs took in $1.1 trillion compared with just $24 billion for mutual funds. That said, as of early 2022, there were still a total of $27 trillion in mutual fund assets versus $7.2 trillion in ETFs, according to the Investment Company Institute (ICI).
Let’s start with a basic comparison. Take a look at the table below.
So, what might these features (or lack thereof) mean for you as an investor? In other words, what could they help you accomplish, and what demands or limitations might they place on you as an individual investor?
To answer these questions, here’s a brief summary of some pros and cons of ETFs versus mutual funds.
With ETFs, you can trade more flexibly because these products are traded intraday. Your minimum investment requirements are generally lower than mutual funds. Daily holding disclosures make ETF investing more transparent. And finally, unless you’re invested in mutual funds through an IRA, ETFs might be more tax efficient because you’re generally required to pay taxes only on closed positions that realize capital gains, whereas (non-IRA) mutual fund holders may be subject to taxable events when fund managers realize gains in the course of rebalancing a portfolio by turning over assets. A 2021 study by S&P Dow Jones Indices found that in 16 of the 18 categories tracking U.S. equities-focused funds, more than half the funds underperformed their benchmark. In particular, 98.6% of large-cap growth funds failed to beat the S&P 500 Growth index, making it the worst performing of any U.S. equities category in the past 21 years. Some might conclude, then that a “passive” investing model that invests in funds that target an index might be an appropriate strategy. This may explain, in part, the popularity of index-based mutual funds and their common appearance in retirement plans. ETFs have certain tax advantages, such as not delaying capital gains distributions and permitting investors to harvest tax losses. Consider consulting a qualified tax advisor on these issues.
Although ETFs are professionally managed, they generally do not offer the same level of “active management” as mutual funds. As a self-directed ETF investor, you might need to take a more active role in monitoring, reviewing, and potentially rebalancing your portfolio. This self-directed approach might require additional time and effort. Also, if you plan to actively trade the assets in your account, or if you plan to make incremental additions to your ETF holdings, remember that multiple trades can be subject to intraday volatility.
With mutual funds, you have the choice of investing in passively managed and actively managed funds. Passive funds are similar to most ETFs in that they track a specific benchmark, such as the S&P 500® index. But only through mutual funds can you benefit from a professional fund manager’s efforts to actively manage your portfolio and rebalance it in response to big-picture economic fundamentals. This in itself is a major advantage offered by mutual funds; one that is largely absent in ETFs, and one that may be appealing to investors who prefer a more hands-off approach to investing.
Good fund managers know the “ins and outs” of portfolio construction. They understand the intricacies of particular sectors in relation to the wider economic landscape, and they’re seasoned market participants who probably have weathered several market downturns and other unfavorable economic conditions in pursuit of overlooked and undervalued assets. Although mutual funds might not have the “intraday” trading convenience of an ETF, as funds are purchased or “redeemed” end-of-day either directly through the fund’s issuing company or through a broker, mutual funds nevertheless offer the convenience of direct automatic purchases; a feature that ETFs do not offer.
Some mutual funds have high asset turnovers, which can mean more transaction costs and a larger capital gains tax bill. Fund managers report their holdings quarterly or semiannually; this means that you won’t always know the details or frequency of each transaction. And finally, mutual fund holders may also be required to pay 12b-1 fees: annual marketing and distribution fees that are part of a fund’s operating expenses. Bear in mind that these “expense ratios” are characteristic of both mutual funds and ETFs. And some mutual funds may come with higher or lower expense ratios than other funds or ETFs. So be sure to read a fund’s prospectus carefully to determine whether its strategy and costs may be suitable for your investment goals.
In short, both products come with their own set of advantages and disadvantages.
But which product—mutual funds or ETFs—might better serve your financial goals, match your risk tolerance, or align with your investment style? Ultimately, it depends on the type of investor you are.
How actively do you plan to invest? How much time are you willing to spend on monitoring your portfolio? How much effort do you want to put into enhancing your investing acumen? Let these answers guide you as you compare ETFs and mutual funds.
And keep in mind, some investors still prefer to build their own portfolios rather than use either ETF or mutual funds.
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Mutual funds are subject to market, exchange rate, political, credit, interest rate, and prepayment risks, which vary depending on the type of mutual fund.
Diversification does not eliminate the risk of experiencing investment losses.
ETFs can entail risks similar to direct stock ownership, including market, sector, or industry risks. Some ETFs may involve international risk, currency risk, commodity risk, and interest rate risk. Trading prices may not reflect the net asset value of the underlying securities.
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