ETFs vs mutual funds: similarities and differences
Due to their popularity in retirement plans like 401(k)s, mutual funds continue to lead the pack in terms of total assets. According to the Investment Company Institute, U.S. mutual funds had about $23.9 trillion in assets by the end of 2020, compared to $5.4 trillion in ETFs. However, investors have been drawn to ETFs during the past ten years because of their low costs and simplicity of trading.
You can invest in a diversified portfolio using either type of fund by purchasing only one security. For instance, you can purchase an index fund based on the S&P 500, a ranking of the 500 largest American corporations, as a mutual fund or an ETF. Or you may use either to purchase a collection of bonds. Some funds let you purchase things like gold or every business in a particular sector.
An overview of mutual funds
An older method of enabling a group of investors to own a portion of a larger portfolio is through mutual funds. Since they are frequently actively managed and aim to outperform their benchmark, mutual funds may have higher expenditures than ETFs, including the potential for sales commissions. Commonly, mutual funds have minimal initial purchase requirements and can only be bought after the market has closed, at which point their net asset value (NAV) is determined.
An overview of ETFs
ETFs are a more recent method of enabling investors to own a portion of a bigger portfolio. ETFs frequently follow a predetermined index of assets rather than having a portfolio manager choose their holdings, which is known as passive management. They often have little overhead costs and no sales commissions. Even though certain brokers would not let you purchase fractional shares of ETFs, they often do not have a minimum initial purchase requirement. ETFs can fluctuate in price around their net asset value and are traded throughout the day like stocks.
Managing actively versus managing passively
Your costs and potential profits are heavily influenced by how a fund actually makes investments. Some funds use an investment strategy known as active management, in which the fund manager decides which stocks to buy and sell and at what point. This method is more frequently used with mutual funds.
The alternative strategy is known as passive investing, and it entails the fund manager imitating an index that has already been chosen, such the S&P 500, rather than choosing the investments. Despite the fact that ETFs can occasionally be actively managed, this method is more typical of ETFs.
Therefore, in general, ETFs have been passively managed while mutual funds have been actively managed. However, these distinctions are no longer as clear-cut, and it is now possible to discover mutual funds that are both actively and passively managed.
The profits you’re likely to see as an investor and the expense ratio you’re going to incur are two major factors for which this difference is significant.
Fund expenses and returns
The conclusion of the active vs. passive investment argument is that passive investing performs better most of the time. In fact, a new research from S&P Dow Jones Indices reveals that over a 20-year period ending on December 31, 2021, 90% of U.S. active managers in major corporations failed to outperform the market.
Yes, the top funds can outperform their benchmarks—often the S&P 500—in a given year, but active managers struggle to excel over the long term.
The objective of passive investing is not to outperform the market, as is the case with active managers. Passive investors, on the other hand, merely want to mimic the market. Additionally, as passive investing outperforms the majority of investors, you can defeat the majority of active professional managers.
ETFs, which are normally passively managed—again, some mutual funds are also passively managed—benefit from this.
Another drawback of active management is that it typically costs more than a fund that is passively managed. The cost of mutual funds has decreased as a result of the advent of cheaper ETFs.
Expense ratios for funds have been decreasing for the past 20 years, as seen in the chart below. Whether you compare the costs of stock mutual funds using a simple average or an asset-weighted average, they continue to be higher than those of ETFs (factoring in how big the fund is).
Compared to ETFs, are mutual funds safer?
Because of how they are structured, neither the mutual fund nor the ETF is more secure than the other. What the fund itself owns determines how safe a position is. Bonds are typically less risky than stocks, while corporate bonds are slightly riskier than U.S. government bonds. Higher risk, however, may result in higher long-term returns (particularly if it is diversified).
Because of this, it’s important that you comprehend the features of your investments, in addition to whether they are mutual or ETF funds. You won’t be exposed to greater risk one way or the other because a mutual fund or exchange-traded fund (ETF) tracking the same index will produce roughly the same returns.
Which should you choose—ETFs or mutual funds—and why?
Since mutual funds and ETFs function similarly in many respects, the best long-term decision mostly depends on the fund’s actual investments (the types of stocks and bonds, for example). For instance, the performance of mutual funds and ETFs based on the S&P 500 index will be basically the same for you. However, the way in which actively managed funds are invested can have a significant impact on the outcomes.
However, the discrepancies are found in the fees, commissions, and other expenses related to your selection. And ETFs outperform mutual funds in these areas. Additionally, they have an advantage in terms of tax efficiency, which lowers your entire tax burden.