The growth in the number and types of mutual funds and exchange traded funds have made it possible for beginner investors to create portfolios with more diversity with smaller amounts of money.
Here are the differences so you can decide which is best for your investment objectives.
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What Is a Mutual Fund?
A mutual fund is an investment vehicle that pools money from a group of investors to purchase securities such as stocks and bonds or commodities and even alternative assets such as real estate.
The firm's objectives determine the types of investments that it purchases. For example, a fund looking for capital gains would hold mostly stocks, while funds seeking income will purchase mostly bonds.
You can purchase shares in a mutual fund through a brokerage firm or directly from a fund company such as Fidelity or Vanguard.
How Does a Mutual Fund Work?
When you purchase shares in a mutual fund, you are buying a share of all the investments in the fund. As a result, you are able to take a small investment and create a diversified portfolio. The share price of a mutual fund is determined at the end of each day when the market closes by calculating its net asset value (NAV).
A professional fund manager oversees the portfolio of securities and makes decisions of when to buy and sell. This manager makes their decisions at their discretion with the goal of increasing the net asset value of the fund. Actively managed mutual funds charge a management fee, known as the expense ratio, for these services. These funds may also charge a sales load that reduces the amount of your initial investment when you first purchase shares in the fund.
Index funds that follow a stock market index, such as the Standard & Poor's 500, have lower expense ratios since the stocks in the fund are passively following the index, and a professional manager is not buying and selling the securities.
Mutual Funds Pros and Cons
There are pros to investing in a mutual fund.
- Diversification: Your investment could be potentially spread over a hundred or even a few thousand securities.
- Low minimum investment: Although some mutual friends may require an initial investment of several thousand dollars, you can get started in other funds for as little as $1.
- Easy to purchase: You can buy into a mutual fund for any amount of money. You don't have to worry about having enough funds to purchase an entire share.
Investing in a mutual fund also has some cons.
- Possible High fees: The initial sales charge and expense ratio for managing the fund can be substantial.
- Tax consequences: Since mutual funds are required to distribute capital gains to its shareholders, you could wind up owing a capital gains tax even if you haven't sold your shares during the year.
Mutual funds and exchange traded funds are excellent investment vehicles for beginner investors to start building an investment portfolio.
What Is an Exchange Traded Fund?
An exchange traded fund (ETF) is a security that has a diversified portfolio similar to a mutual fund but has the flexibility of being bought and sold like a separate stock. ETFs can invest in a wide range of securities – such as stocks, high-grade bonds, junk bonds, treasuries with long- and short-term maturities, commodities and foreign currencies. They can also mimic a benchmark index like the S&P 500.
How Do ETFs Work?
An ETF creates a portfolio that consists of the securities that meet the objective of the fund. Unlike a mutual fund, the financial institution that operates the ETF owns the individual stocks or underlying securities in the portfolio and adjusts the number of outstanding ETF shares to set the share price on the stock exchange.
Shares of ETFs trade daily and prices fluctuate based on market forces just like any other stock price. You can buy and sell shares of an ETF through your broker at any time during a trading day, which means you could incur brokerage commissions and transaction fees.
ETF Pros and Cons
ETFs have several advantages.
- Diversification: An investor gains the diversification spread across a group of securities or market segments.
- Able to trade shares: Shares of ETFs are traded throughout the day and can be either sold short or purchased on margin.
- Lower fees: Passively managed ETFs have lower expense ratios.
- Tax consequences: Since the investor does not own the underlying securities in an ETF, there aren't any capital gains consequences on changes in the prices of those securities.
ETFs also have cons.
- Less diversification: Even though the portfolio of an ETF may contain a large number of securities, adding to diversity, these securities may be limited to a small sector such as small-cap companies, or a particular geographic region, like Asian countries, which would reduce diversity.
- Low trading volume: Most ETFs have low trading volumes, which means the bid/ask spread may be wider compared to most stock prices and result in the investor paying more for the shares of the ETF or getting less when they sell.
ETF vs. Mutual Fund
There are key differences between ETFs and mutual funds.
- Kind of management: Mutual funds typically have professional fund managers who try to beat the market return by buying and selling securities. ETFs on the other hand are usually passively managed and automatically track a stock market index.
- Expense ratios: Since ETFs are passively managed, their expense ratios are usually less than actively managed mutual funds.
- Trading: Shares of ETFs can be traded throughout the day whereas mutual funds can only be bought and sold based on their net asset value at the end of each day.
- Taxes: ETFs are more tax-efficient than mutual funds. Because of their structure, mutual funds tend to produce higher capital gains liabilities because of the active management of buying and selling the underlying securities. With ETFs, you only incur a capital gain if you sell the shares of your ETF at a higher price than you paid for them.