ETFs vs mutual funds: what’s the better investment?

Mutual funds and ETFs are both popular investment tools with some key similarities and differences. In this article, we’ll go through the basics, the pros and cons, and the types of investors each might attract. We’ll discuss important points to consider when investing in mutual funds and ETFs: cost of investing, expected returns, ease of trading, and flexibility. Here’s a side-by-side review of ETFs vs mutual funds.

What are Mutual Funds?

Mutual funds are a type of financial tool that gathers finances, also known as “pool assets”, from different investors or shareholders. These are then used to invest in bonds, stocks, money market and other financial assets. Each shareholder of mutual funds participates in the gains or losses of the funds.

The mutual fund has fund managers, also called investment advisers, who are legally obligated to work and allocate the pooled funds to produce capital gains or income. The investments are continually tracked by the managers to ensure that the funds are keeping up with the market and make changes if necessary.

What is an ETF?

Exchange-traded funds or ETF is another type of investment that is registered under the SEC or Securities and Exchange Commission. Just like mutual funds, ETFs gather a number of investors to have pool assets and are used in investing in stocks, bonds and other financial assets. But what makes ETF different from mutual funds is that the investment advisers are SEC-registered as well. 

Also, compared to mutual funds, ETF shares are traded on the national stock exchange at a market price that may or may not be like the NAV or Net Asset Value. The value of the ETF is calculated at ETF asset minus liabilities divided by the number of shares.

Lastly, there are types of ETFs that are passively managed which seek to achieve the same return as the market index, also known as index funds. But the most common is the actively managed funds that buy and sell investments.

ETFs vs mutual funds: what’s the difference?

It has been mentioned above that ETF somehow works like mutual funds, but they differ in some aspects, such as:  

Management

Exchange-traded funds can be passively or actively managed by the fund managers and are linked to an index’s performance. Mutual funds are usually actively managed, and both come in active and indexed varieties. 

Trading

Transactions or trades on mutual funds are made once a day and investors receive the same price on that same day. On the other hand, ETFs are traded like stocks where it is bought and sold on the stock exchange which experiences changes throughout the span of the day.

Minimum investment

Since ETFs are traded like stocks, there is no minimum investment required. You can even purchase an ETF for the price of one share which is known as “market price.”

Mutual funds, meanwhile, require initial investments at a flat dollar amount and shares can be purchased in fractional shares.  

Costs

The most surprising difference between the two is the cost. ETFs come with implicit and explicit costs. Mutual funds can be purchased without any trading commissions, but they may come with operational expenses like sales loads or early redemption fees.  

Tax efficiency

ETFs generate fewer capital gains since they have a lower turnover and use the in-kind redemption process for the cost basis of their holdings. But in mutual funds, you are still eligible to receive capital gains from the generated sales of the finances held in the mutual fund even if you experience loss in your investment.

ETF vs mutual funds: pros and cons

Now that you know the difference between an ETF vs mutual funds, let us now look at their advantages and disadvantages.

ETF pros

ETFs will have the following benefits for investors:

• Diversification: The ETF can give you access to different market sectors, stocks, and other financial assets. It can also allow you to follow bigger equities.
• Liquidity: ETFs are at an advantage in the market’s unpredictable circumstances because they can be exchanged on stocks at any time of the day.  

#ETFs vs. #mutual funds? Both deliver diversification, can be held in registered plans and are subject to sound regulations. BUT...ETFs are typically available at a lower cost and are more tax-efficient. Originated in Canada. Available for more than 30 years. pic.twitter.com/9nrngNGOHc

— CETFA (@cetfassn) December 14, 2022

• Lower cost ratios: Since ETFs can be passively managed, they can have lower cost ratios compared to mutual funds. The common cause of high-cost ratios may include service fees, marketing, load fees and management fees.
• Immediately reinvested dividends: In an open-ended ETF, dividends are immediately reinvested. But there is one rule that applies, and that is that dividends paid through unit investment trust ETFs are not automatically reinvested which causes dividend drag.
• Lower discount or premium in price: Compared to mutual funds, ETFs can help you save some money. Not just because it is passively managed, but because it has lower capital gains. (Mutual funds are actively managed.)

ETFs cons

Even though ETFs provide great benefits, there are still downsides that should be taken into consideration:

• Limited diversification: Since ETFs are not exposed to a bigger market index, they may miss out the exposure to mid and small firms.
• Excessive intraday pricing: Investors may experience delayed fluctuations in the hourly prices which result in more trading. Long-term investors may not gain much due to intraday pricing fluctuations.
• Dropping dividend yields: There is a type of ETF that earns through dividends called dividend-paying. Their yields may not be profitable like high-yielding stock or a group of companies. One good thing to consider is that the dangers of having ETFs are at a low percentage, but if you are a high-risk investor, you may consider doing stock dividend payouts. 
• High costs: Investors looking at ETFs tend to compare this trading to other trading funds. When ETFs are compared to investing in a single company, the costs may then reach a high level.

Mutual funds pros

Mutual funds are known due to its concept of sharing finances with other investors to generate a pool of funds that can be used for bigger investments. What are the other reasons why many investors pick mutual funds? Here are some benefits that you can have when you choose this as your investment tool:

• Attractive returns: Mutual funds can generate an annual return of 10%-12%. If it does really well, it can give a return up to 20%, or even more. One of the best and long-term performers in mutual funds are the funds that are based on S&P 500.
• Convenience: It is convenient to invest in mutual funds because you can do them in different accounts like individual retirement accounts (IRA), employer-sponsored retirement accounts, or through a brokerage account.
  • All you need to do is buy the number of shares that you want to purchase and wait for the confirmation that the order is fulfilled.  
  • Another thing that makes mutual funds a convenient investment tool is you can automate the process of buying.
• Low fees: Mutual funds give you a 0.03% or 0.04% annual expense ratio, which converts as $3 or $4 dollars for every $10,000 you have invested. With the lower fees that mutual funds have, you can maximize the returns of your invested money. 
• Built-in diversification: Unlike ETFs, mutual funds have their own diversification option which makes them less volatile. Mutual fund managers invest in different large companies which helps in avoiding the impact of any company having a deficient performance. 
• Professional management: When you choose a mutual fund as your investment tool, you do not have to worry about how you would buy or sell any shares. The fund managers will do all the work for you, which also helps you to save time when managing your portfolio.
• Dividend reinvestment: With mutual funds, you can take advantage of automatic reinvestment of any cash dividends. If the mutual fund pays out capital gains or dividends, that profit can be reinvested without paying any fees.
   

Mutual funds cons

Of course, when there is a benefit, disadvantages automatically come along the way. Here are some disadvantages of the mutual funds:

• High fees: The broker that you will work with may charge you a sales load to buy or sell the fund. Other companies may even ask for a commission fee which can amount to 1% or 2% of your total investment.
• Uncontrollable tax events: It is given that fund managers will do all the work in generating returns on your funds. But when a mutual fund sells securities from its portfolio, it may cause a year-end distribution to investors which are taxable investment income. 
  • These distributions may be taxed based on capital gains rates or ordinary income rates. Rate implication will depend on how long the fund has been held as an investment, which can cause a higher-than-expected tax bill.
     

ETFs vs mutual funds: why invest in mutual funds?

 There are tons of mutual funds investors who realize that mutual funds would fit in with their financial goals. Here are other reasons why people choose to invest in mutual funds:  

• Mutual funds work for a long-term investor which encourages the investors to stay in their pool assets even though the financial market is constantly changing.
• With mutual funds, it is guaranteed that the assets are properly handled by professionals.
• The convenience of automatic contribution makes investing less stressful.

ETFs vs mutual funds: why invest in ETFs?

But what about the exchange traded funds (ETF), why would you think that it is a clever idea to invest in this kind of investment tool? Is it because the ETFs are purchased and sold within the day of transaction? The flexibility it can give to its investors? Or is it highly suitable for those who enjoy handling their own investments? The answers to those question can be the following:

• Exchange traded funds can be a great portfolio for diversification
• The prices of ETFs are continually changing which spikes the interest of everyday traders and long-term investors
• Exchange traded funds do not require minimum investment, making it a low-cost portfolio which attracts beginners in the investment industry. 
• In terms of disclosures, ETFs are more transparent and easier to understand. Most of the companies offering ETFs provide the full list of holdings on their company website that can be accessed by anyone.
   

ETFs vs mutual funds: which is better?

Choosing between ETFs and mutual funds is a task that can only be answered by yourself. In this article we went through the basics of ETFs and mutual funds, their differences, and the advantages and disadvantages they have.  

What you need to do now is to identify the financial goal that you would want to achieve for you to be able to pick which type of investment tool will be suitable for your preference, needs and objectives.   

Investing is not a one-day process. So whatever investment tool you choose, be patient in expecting profits, returns or capital gains of your portfolio.

What are your thoughts on ETFs and mutual funds as investment tools – would you recommend one over the other? Let us know in the comments below: