People often think that mutual funds and exchange-traded funds (ETFs) are pretty much the same thing. You know, since they both have the word “fund” in them and all.
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Same difference right?
In reality…they’re two very different things. ETFs and mutual funds are both vehicles designed to make it easier to invest – and although ETFs and mutual funds do share a bunch of qualities – it’s important to understand their significant differences. Let’s talk about why ETFs are just…kind of better than mutual funds.
Even though mutual funds and ETFs share similar traits, there are differences between the two that make ETFs stand out as the superior choice.
1. Flexible Trading Process
ETFs have greater flexibility than mutual funds within the trading process.
Sales and purchases of a mutual fund take place directly between investors and the fund, and the price of said fund is not determined until the end of the business day, when the NAV (Net Asset Value) is determined.
On the other hand, an ETF behaves similarly to a stock and its shares trade throughout the day between investors just like any other stock. ETFs allow you to trade on the major stock exchanges at anytime during the trading day. Their prices will fluctuate throughout the day, just like a share of Google or Apple, but mutual fund shares are priced once a day after the markets close.
The key difference is that you can only buy a mutual fund at the NAV price set at the end of each business day. This is what we’d call a “true price” and because of that there’s not much room for making smart trades. It’s much harder to find an undervalued mutual fund than an ETF, simply because of the way prices are set for the different instruments.
2. Lower fees
The fees you will pay on an ETF are going to be much lower than those of most mutual funds.
There’s a reason for that, of course. ETFs are generally passively managed, or managed by a computer, while mutual funds can have active management. You have to pay extra for that!
ETF fees range from 0.10% on the low end to 1.25% at the high end. Mutual fund fees can be as low as 0.2% and as high as 2%.
That doesn’t sound like too much of a difference…but the problem is this: the fees on mutual funds don’t stop there. See, that range we quoted merely takes care of what’s called an expense ratio (i.e. mutual fund fee). The mutual fund industry is notorious for hiding other costs under layers of financial jargon. The average investor doesn’t even know to look for them, and they definitely aren’t told that the fees are being applied. They just don’t realize how much money they’re being taken for.
In addition to the expense ratio, there are what’s called “loads”. A load is a fee that you pay for the privilege of having someone sell you the mutual fund. A front-end load is applied when you buy the mutual fund and a back-end load is a fee that is applied when you sell the fund. These can be as high as 5%.
You need to watch out for fees, as they eat into your investment returns with zero remorse. By choosing an ETF over a mutual fund you can make sure that you’re saving more for retirement and not just giving away your money via sales commissions.
Because ETFs don’t have to manage hundreds of customers, they have lower fees that translate into higher returns for you. Be careful, though, because the costs of trading an ETF can more than offset the initial advantage of an ETF’s lower expense ratio. Because of that, an ETF will be the most cost-effective choice for those who use discount brokers, invest a large amount of money, and hold on for the long-term.
3. Reliable Performance
If there’s one major advantage in favor of ETFs, it would be that the variance of the performances between ETFs is lower than that of mutual funds. Put another way, mutual funds are all over the shop when it comes to performance. They can go really low or really high. ETFs tend to perform within a tighter range.
A lot of this is, again, due to the fact that ETFs are passively managed while mutual funds have humans at the helm. Some of those humans are amazing at their jobs, some are lucky and some are just plain bad.
ETFs are far more tax-efficient than mutual funds.
Because they’re not churning their portfolios in search of better stocks, ETFs don’t run up a lot of capital gains that must be distributed. Think about it, as a manager of a mutual fund, you have to find a way to justify your fee. It’s unfashionable to buy and hold, so these active managers will buy and sell many stocks over the lifetime of your investment.
This turnover generates capital gains. Every time you sell a stock and the price has gone higher you’ve made money. According to the law, if a fund builds up capital gains, then it must pay them out to shareholders at the end of the year.
As passively managed portfolios, ETFs and index funds tend to realize fewer capital gains than actively managed mutual funds. They are more tax-efficient for this reason. If you don’t sell the ETF share then there are no capital gains.
The big difference here is that you hold the power.
You now have a better idea as to why ETFs are often considered better than mutual funds. ETFs cost you less, give you more control and are way more transparent than shadowy mutual funds that make it very hard for the average investor to make decent returns.
Maybe this was more than you ever wanted to know about the differences between ETFs and mutual fund but it certainly doesn’t hurt to be informed. After all, knowledge is power.