Once you’re ready to take the plunge and invest, the options can seem overwhelming. Should you choose stocks or bonds? Domestic investments or international funds? Does one have a better return or more advantages than another?
Mutual funds and exchange traded funds, or ETFs, are two types of investments that eliminate a lot of those little uncertainties. Each pools money from investors into a collection of securities so that you don’t have to purchase or manage individual assets to have a diverse portfolio.
However, you still have a decision to make: whether to invest in a mutual fund or an ETF. Although these investment types are generally similar, they vary in how they’re managed and how much money you can make with each.
Let’s compare ETFs and mutual funds so that you can decide which option is better for you.
What is an ETF?
As its name implies, an ETF trades—or buys and sells assets—on an exchange, such as the stock exchange. An ETF combines a pool of assets, such as domestic or international bonds or stocks, or follows the value of a commodity, such as gold.
When you invest in an ETF, you become a shareholder, meaning that you own a portion of these assets. Through buying and selling shares through a brokerage account, you can earn lump-sum dividend payments depending on how those assets perform.
According to the Investment Company Institute (ICI), an entity since 1940 that serves as a voice for investment funds and their shareholders, ETFs have been an “investment product” in the United States for more than two decades. As of November 2020, the combined assets of the nation’s ETFs totaled $5.21 trillion.
Here are some of the most common types of ETFs:
- Broad-market ETFs: A broad-market ETF tracks assets that make up a large part of the stock market, such as SPDR S&P 500, which tracks the S&P 500 Index, or the performance of 500 large U.S. companies from the New York Stock Exchange. Other ETFs might focus on a particular international region or companies of a certain size.
- Sector ETFs: These offer the diversity of investments in an EFT but focus on a particular sector of industry, such as Consumer Staples, Technology, or Health Care.
- Dividend ETFs: These funds, such as iShares Core High Dividend, focus on U.S. companies with high-yield stocks, or those that expect to earn above-average returns over time.
- Style-based ETFs: If you know enough about investing to have a preference for stocks such as those from small companies, or those that focus on growth or value, you can invest in an EFT with stocks of that particular style. For instance, the Schwab U.S. Large-Cap Growth ETF tracks the stock performance of companies growing faster than average.
- Commodity ETFs: These funds, such as the United States Commodity Index, offer a way for beginning investors to deal in commodities, such as natural gas, crude oil, precious metals, and crops such as wheat and soybeans.
- Currency ETFs: To offset the ups and downs in the value of the U.S. dollar, some investors opt for these types of funds; many ensure that a share of the fund corresponds to the value of a certain amount of a foreign currency.
- Bond ETFs: Investors can tap into the bond market through this type of fund, investing in a broad fund such as the Schwab U.S. Aggregate Bond ETF or funds that focus on specific bond types, such as Treasury bonds.
What is a mutual fund?
Similar to an ETF, a mutual fund pools money from shareholders to invest in a portfolio of securities. As a shareholder, you’d earn money depending on how those different securities performed. The ICI says that roughly 102 million Americans owned mutual funds in 2019 to save for long-term goals, such as paying for education, buying a house, or saving for retirement, something 94 percent of households said was their key reason for owning a mutual fund. Many retirement plans such as 401(k)s involve mutual funds.
As of November 2020, the combined assets of the nation’s mutual funds were worth $23.3 trillion, the ICI says. Most of the households owning mutual funds—about 60 percent—are headed by someone in their “peak earning and saving years”: between ages 35 and 64, according to an ICI survey.
Here are some common types of mutual funds:
- Equity funds: Equity funds such as the Vanguard 500 Index Fund include stocks, which as a shareholder gives you a tiny piece of each company in which your mutual fund invests. “[E]quity funds are the most volatile, but they also carry the greatest potential for growth and a higher rate of return over the long haul,” says author and financial expert Chris Hogan, writing on DaveRamsey.com. These funds cluster according to the size of company capital as well as growth, Hogan says. About 90 percent of the households that owned mutual funds in 2020 owned equity funds, according to the ICI.
- Bond funds: Instead of earning returns on stocks, bond funds such as Fidelity U.S. Bond Index Fund invest in corporate or government bonds. Purchasing shares in these funds is similar to lending money to the owner of the bonds with the idea that you’ll get repaid. Sometimes called fixed-income funds because of their steady rates of return, bond funds provide some return on investment but not as much historically as stocks.
- Money market funds: These funds such as the Vanguard Treasury Money Market Fund tend to have a low level of risk and generate income based on government securities, such as Treasury bills and Treasury bonds.
- Balanced (or hybrid) funds: These funds, such as the Vanguard Wellesley Income Fund Investor Shares, combine investments using stocks and bonds, so shareholders can diversify and “streamline investment decisions,” according to U.S. News & World Report. They frequently have a ratio of about 60% stocks and 40% bonds. One type of balanced fund is a target-date fund, where the fund automatically reallocates assets to lower-yield (and lower-risk) options as you grow closer to retirement age.
- Sector funds: Similar to sector ETFs, sector funds invest in a particular economic sector. So if you’re interested in technology, you might choose to invest in a sector fund that includes stocks from tech companies such as Google or Apple. T. Rowe Price Health Sciences is a health sector mutual fund whose holdings include biotechnology, health services, and pharmaceuticals.
- Socially responsible funds: If you’d like to put your money toward a cause that’s close to your heart or be sure that your investments align with your ethics, you can find mutual funds that invest in a range of companies dedicated to particular causes. For instance, Portfolio 21 Global Equity Fund Class R, or PORTX, doesn’t invest in the weapons industry, companies with direct interest in fossil fuel production or exploration, or companies with controversial labor practices, according to U.S. News & World Report.
How are ETFs and mutual funds similar?
ETFs and mutual funds have a number of similarities:
- Both comprise pools of assets, whether bonds, stocks, commodities, or a mix of one or more of these categories.
- Both must adhere to regulations regarding what securities they own, how they concentrate their holdings, and so on.
- Both provide investors with an opportunity to become shareholders by purchasing shares in these funds, giving them a claim on the investment returns.
- Both post a “daily net asset value” at the end of a trading day, or what each share of the fund is worth based on the value of all its securities.
- Both offer a variety of investment strategies to suit an investor’s needs and goals. Investors can choose ETFs and mutual funds known for swift growth or lower risk, or those that focus on domestic assets, international assets, small or large businesses, or companies whose missions align with certain sets of ethics.
- Both have an expense ratio, or a fee that investors pay to the fund sponsor to manage that fund.
- Both have varying average returns, depending on their mix of investments. For instance, as of Dec. 31, 2020, the Vanguard S&P 500 ETF had a one-year return of about 18% and a five-year return of about 103%. By comparison, the mutual fund Vanguard 500 Index Fund Admiral Shares by the same date had a one-year return of about 18% and a five-year return of about 15%.
How are ETFs and mutual funds different?
Even though ETFs and mutual funds are set up to make investments diverse yet simple for investors, they differ regarding their management and how much you can earn. For instance:
- In the short term, actively managed mutual funds may earn more than ETFs. According to The Balance, seven broad categories of mutual funds in 2020 averaged a return of roughly 10%; the largest year-to-date return was about 13.8% for funds dealing with U.S. large-cap stock. Depending on the mix of investments, some ETFs can perform better over the long-term or even year-to-date. In 2020, for instance, O’Shares Global Internet Giants ETF, which focuses on tech stocks, had a year-to-date return of 97%.
- Although ETFs and mutual funds both post a “daily net asset value” (or NAV) each day, they arrive at this value differently, which affects the price of the shares that investors can buy, the ICI explains. If you’re buying shares in a mutual fund, you’ll pay whatever its NAV is at 4 p.m., regardless of when you place your order that day. But because ETFs trade on a stock exchange, their prices fluctuate, so you could pay more or less than the NAV posted at the end of the trading day.
- ETFs tend to have “passive management” because the fund manager mimics a specific market index, according to Investopedia. Mutual funds have “active management,” meaning that the fund manager actively buys and sells assets within the fund to help investors profit.
- Because ETFs trade on a stock exchange, you need a brokerage account if you want to buy and sell ETFs, the ICI says. You can deal with a broker to buy and sell shares in a mutual fund, too, but a mutual fund also allows investors to buy and sell shares through the company that manages the fund or a fund adviser.
- Mutual funds tend to have higher expense ratios and fees than ETFs because of their active management, Investopedia says. However, some mutual funds have lower fees than comparable ETFs, the ICI says. In 2016, the average ETF expense ratio was 0.23%, Morningstar says, compared with 1.45% for actively managed mutual funds.
- ETFs may be subject to brokerage commissions because they’re traded on an exchange. While this cost can vary, it’s generally not higher than $20, Fidelity says.
- They’re taxed differently. You might have to pay capital gains taxes if a mutual fund earns money, even if you haven’t sold your shares, because an actively managed fund passes the gains along to everyone. An ETF investor usually doesn’t pay capital gains taxes unless he or she sells the shares for a profit.
- ETFs aren’t necessarily low cost investments, but they do allow investors to purchase by the share. Mutual funds, even for novice investors, tend to require a minimum fee to invest, such as $1,000 or more.
Here’s a brief comparison chart to summarize some of the similarities and differences between ETFs and mutual funds. Please note that any fund’s individual performance and return on investment will vary:
|Has a varied pool of assets such as stocks, bonds, or commodities
|Must adhere to investment regulations
|Investors have a claim on the investment returns by purchasing shares
|Allows investors to purchase shares instead of meeting a minimum entry cost
|Posts a “daily net asset value” at the end of a trading day saying what each share of the fund is worth
|Charges an expense ratio, or a fee for managing the fund
|May involve a brokerage fee
|Is traded on a stock exchange
|Charges capital gains taxes to all shareholders, regardless of whether they’ve sold shares that year for profit
|Value of its assets changes throughout the day
|Needs a brokerage account to buy and sell
|Can have a higher return on investment over five years or more
Is an ETF better than a mutual fund?
Everyone’s investment goals and needs are different; no one-size-fits-all answer exists. While the tax-efficiency or focus on a particular industry might make an ETF attractive, you might find an index fund with lower annual operating expenses and other fees. Your investment strategy also depends on how much money you’d like to make over a particular span of time and how comfortable you are with risk and the fluctuations of the stock market.
Why choose an ETF over a mutual fund?
If you understand the ups and downs of the stock market and enjoy watching how your shares vary throughout the day, an ETF can be an exciting investment option. While ETFs require a brokerage account and might be subject to brokerage commissions, they don’t charge capital gains tax unless you sell your shares at a profit. That said, while mutual funds might have higher operating fees, they also tend to be sturdy investment vehicles for people who are uncomfortable with volatility and rapid growth.
Do ETFs outperform mutual funds?
Again, it’s difficult to say this across the board. ETFs usually have “passive management,” meaning the fund manager doesn’t select the investments as a mutual fund manager would but follows a particular index, such as the S&P 500.
According to Bankrate, passive investing outpaces active investing “almost all of the time,” with more than 92% of active managers in large companies over a 15-year period unable to beat the stock market.
However, the world of investing changes much like other industries, and you’re likely to find some ETFs with active management as well as mutual funds with passive management.
Should I buy a Vanguard ETF or mutual fund?
Whether you’re interested in an ETF or mutual fund from Vanguard, Schwab, Fidelity, or another financial provider, it’s important to do your research and evaluate whether that ETF or mutual fund aligns with your investment goals and comfort level.
For instance, check out not just the average annual returns but the performance over three years, five years, and ten years. Also look at what the cost of entry is, the portfolio’s investment strategy (value vs. growth, for instance), expense ratio and other fees, and tax liability.
Both ETFs and mutual funds are investment vehicles that enable people to grow their money over time through a diverse portfolio. While Americans have invested more money in mutual funds, ETFs provide ease of trading and performance that might appeal to certain investors.
Ultimately, whether a mutual fund or an ETF is right for you depends on your long- and short-term investment goals and your preferred investment strategy.
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