Mutual funds and Exchange-Traded Funds (ETFs) are different and it is important that an investor should know what these differences are before investing their money. Both funds have disadvantages as well as advantages. However, it is interesting to note that, for an investor, both ETFs and mutual funds can be used in an optimal combination to build a solid and strong portfolio. Firstly, given below are a few similarities between ETFs and mutual funds.
Similarities between mutual funds and ETFs
Both ETFs and mutual funds enable investors to buy different securities in one basket as a single source of investment.
Both mutual funds and ETFs invest within a specific category of stocks, bonds, etc., and within an implied objective such as increased value, growth or income.
A majority of ETFs are passively managed and this makes them look very much like index mutual funds. Both index funds and ETFs actually mirror the performance of the index which is the underlying asset of the fund. The expense ratios are low as the cost to manage and distribute the ETFs is very low. They are considered as a good option for investment diversification and also to build a strong and solid portfolio for the investor.
Differences between Exchange-Traded Funds (ETFs) and Mutual Funds
The basic difference between ETFs and mutual funds is the manner in which they are traded. This means the way in which investors can buy and sell shares belonging to these funds. As an example, if an investor wants to buy or sell a mutual fund, the price at which it is done is referred to as the net asset value (NAV) of those underlying assets that make up the fund. The value will be that which the investor trades at the end of a trading day.
In the above case, if the stock prices fall or rise during the day, the investor will have no control over the time at which the trade is executed. The end of the day price may be better or worse in the case of mutual funds.
In the case of ETFs, trading can be done intra-day. That is, the investor can take advantage of the price movement directions that take place within a specific trading day. As an example, if you notice that the market is moving in the positive direction during the day, you can buy an ETF early during that trading day and sell it for a higher price later in the day. It can happen that the market moves by as much as 1 percent in either the positive or the negative direction. This kind of difference in the market condition reflects both opportunity and risk. It also depends on the investor’s capacity to predict the direction of movement of the market.
One aspect of trading ETFs is spread or the difference between the bid and ask price of the security. For ETFs that are not popularly traded, the spreads are wider and represent a risk for the investor. Therefore, to be able to make more profits, it is a good idea for investors to trade in popularly traded Index ETFs such as iShares Core S&P500 and SPDR S&P500. It is not a good idea to use ETFs of country funds and sector funds that are narrowly traded.
Another stock-like character that ETFs display is the ability to place limit orders. With this facility in place, the investor can choose the price at which the trade may be executed. Similarly, the investor can also place a stop order can choose a specific price that is below the current one to prevent a loss when the ETF can be sold to prevent a loss if the market price goes below the stop loss price. This amount of flexibility is not available with mutual funds.
The expense ratios of ETFs are lower than most of the index mutual funds. Theoretically, this means better returns for the investor that has invested in ETFs than when he invests in mutual funds. ETFs that track indices are cheaper than index-tracking mutual funds. Both ETFs and mutual funds are open-ended. But the way in which the number of shares is adjusted in both is different.
When the money inflow is higher into the mutual fund on any day, the extra money has to made to do work in the marketplace. However, when the outflow is more, some of the holdings have to be sold if the net amount of cash is insufficient. With ETFs, the providers want to keep their price as close as possible to the NAV of the index. To keep it in place, the managers merely adjust the shares’ supply through the redemption of old shares or through the creation of new shares.
The ETF structure is such that it results in higher tax efficiency when compared to mutual funds. Investors of both ETFs and mutual funds are taxed every year based on the incomes and losses that have incurred within the portfolios. As there is less amount of internal trading in ETFs, there are fewer taxable events. Actually, the redemption and creation of shares decrease the requirement for selling.
Mutual funds, on the other hand, distribute the taxable gains to the investor unless the investment has been done in a tax-friendly manner or through 401 (k). This is true even if you simply hold the shares. If you have a portfolio with only ETFs, the tax becomes an issue only if you sell the shares.
ETFs are relatively new in the market. Therefore, if an investor wants to move to ETFs, selling the existing mutual funds may attract capital gains taxes. Therefore such investors have to be aware of this factor.
To the question, which is better, ETFs or mutual funds, the answer is that it depends on individual investors and their needs. For those that want to invest in obscure sectors, mutual funds may be better. For others who to keep the portfolio and its management simple, ETFs is definitely a better choice.