Investment Basics: Should I Buy a Mutual Fund or an ETF?

Posted on January 25, 2021 at 4:10 PM PST by

Many investors, even experienced investors, now face a choice when it comes to investing in stocks and bonds, namely, should they use a mutual fund or an exchange-traded fund (ETF)?

Mutual funds have a long history. ETFs, meanwhile, are relatively new. Investors increasingly can find ETF versions of long popular mutual funds, usually at a lower cost.

So which is best and what are the differences?

First off, in most instances the difference in terms of the underlying stock investments is virtually zero. Many brokerages are producing ETF versions of existing funds that track the same stocks or bonds and perform in virtually the same way.

Often, the cost of the ETF version of an existing mutual fund is lower. Since cost can be a drag on long-term return, paying less for the same product is immediately attractive.

However, it’s important not to assume that because a fund is called an ETF that it’s cheap. The ETF structure is a way to create a fund that is tax efficient and cheaper to run, but some ETFs track exotic benchmarks or use leverage to aim for short-term gains.

For example, some ETFs track foreign or illiquid assets and, as a result, they are expensive to own. Sometimes, performance is hard to document or irregular due to so many moving parts, such as currency fluctuations or relatively small market capitalizations.

Secondly, any ETF that is labeled “2x or 3x” or “inverse” typically relies on leverage to approximate the movement of a larger index but magnified in one direction or another. Unless you know what you are doing, steer clear of these products.

Nevertheless, it has become common for most popular ETFs to follow a broad, widely traded index, such as the S&P 500 or investment grade bonds. They become, in effect, a type of index fund, with similarly attractive low pricing.

In comparison, many mutual funds are actively managed, meaning you pay a fee to the fund’s managers to select stocks on your behalf, in hopes of exceeding the broad market return.

So what are the differences between ETFs and mutual funds?

A big, immediate difference is trading. With any ETF you can trade the ticker during market hours, like a stock.

That means you can do a market order to sell or buy and have it filled nearly immediately, if the ETF is widely traded enough. It also can be sold short.

In the case of a mutual fund, the price is set at the end of the trading day. You can sell at any time, but you will get that price and only that price. The published price is called net asset value (NAV).

Pricing power

Another important difference is initial investment required. ETFs are easy to get into. Usually, the initial investment is just whatever the price of a single share might be the day you decide to buy.

That’s because ETFs are traded on the open market and, commonly, there are plenty of buyers and sellers of any given ETF that interests you. Often, trading commissions are low or free, too.

In the case of a mutual fund, the managers of the fund have an interest in making sure that their work in running the fund is efficient. They have to physically buy and sell shares of their selected stocks. When a new investor wants in, that means an increase in their workload.

As a result, most mutual funds set a minimum investment in the hundreds or thousands of dollars and some funds even close to new investors.

Furthermore, there are two kinds of mutual funds: open-ended and closed-end.

An open-ended fund can have an unlimited number of shares. The managers must revalue the funds daily to manage the number of shares relative to the stocks they buy for investors.

A closed-end fund issues a specific number of shares and no more. That means the NAV can fluctuate based on investor demand.

Ultimately, investors must decide if they want to own a fund for its underlying investment choices and potential performance characteristics in their portfolio. Cost is an important factor, as well as tax efficiency.

Most brokerages have full-time advisors who can walk you through the differences between two funds and their pros and cons relative to your personal investment goals.

MarketRiders, Inc. is a registered investment adviser.  Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies.  Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.




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