After writing about robo-advisors, several people asked me about the difference between exchange traded funds (ETFs) and mutual funds. Here are some of the main similarities and differences.
Similarities
Baskets of investments. Both ETFs and mutual funds are made up of many underlying investments. Take a stock mutual fund: instead of just buying one stock you can buy a fund that contains many different stocks. Having more than one stock can help to lessen risk versus buying only one stock because of the benefits of diversification. However, know that some stock funds and ETFs are very tightly focused, so while they consist of many stocks they still may fluctuate more than an overall index fund.
May have professional management. While both ETFs and mutual funds provide choices that mimic an index – such as the S&P 500 – they also provide actively managed funds where a lead investor or team is picking the underlying investments that make up the fund. They determine the number of shares of a particular company to purchase, if/when they are bought and sold, and how much to keep in each investment option (ie stocks versus cash).
Provide an easier way to invest. If you’re going to invest in an individual stock, you will need to have at least some knowledge of the actual company and its finances, its place in the sector, how the overall sector is predicted to perform, different price points where the stock might be considered cheap, a buy and sell strategy, etc…all while keeping track of ongoing news about the company. Some people love the challenge of picking a winner. Others only want to check their portfolio’s performance at the end of the year and call it a day. Funds can provide an easier way to invest for the future without having to track every change or event for a particular stock.
Differences
Active vs passive. I mentioned above that both ETFs and mutual funds may be actively managed. In the universe of ETFs you’ll find most are passively managed with corresponding lower fees than actively managed funds. However, this doesn’t mean that all ETFs will be priced lower than a comparable index mutual fund.
Buy or sell. One of the biggest differences between the two is in how you can buy and sell the funds. Mutual funds are settled every day at the close of market. What that means is you can place an order any time during the day, but it doesn’t take effect (nothing is bought or sold) until the closing price is set; then your shares are traded.
ETFs trade much more like stocks, in that you can buy and sell throughout the trading day through your broker. As with stocks, you can place limit, stop, or market orders when purchasing an ETF. With an exchange traded fund, you will find the same type of spread between ask and sell prices as you’d find with a stock. Many ETFs have tiny spreads, but some can be larger if they aren’t traded widely.
Early withdrawal penalty. Some mutual funds may impose a fee for early withdrawal, a period of time that can be a month or longer. If you’re a buy and hold investor, this shouldn’t be a problem. However, you won’t find the same restrictions with the majority of ETFs.
Initial minimums. Some mutual funds require a set amount of money to open an account, perhaps $500 or $1,000. Many will waive that if you have an automatic withdrawal deposited regularly in your account. Minimums and withdrawal penalties shouldn’t scare you away if you truly want to invest in a fund. I recently purchased a fund that not only required $2,000, but also had a 90-day window where if I withdrew my funds I would pay a penalty. However, I wanted to invest in that fund and knew I wouldn’t sell during that time period. There are many funds out there that require neither. Do your homework and find the fund that best meets your needs.
Expenses. As noted above, you will often find lower expense ratios with ETFs than with a mutual fund, especially if it’s actively managed. However, expense ratios for an index fund should be similar across both platforms; you might find a lower fee with a mutual fund or with an exchange traded fund. Know that unless your brokerage offers the ETF at no commission, you will have to pay the normal commission for your purchase and sale decisions. There are many ETFs available at no commission – make sure you check before setting your heart on one where you have to pay to trade.
In the end, if you’re looking for a Russell 2000 index fund, look at the performance and fees across both mutual funds and exchange traded funds. Check with your broker to see what ETFs they offer at no commission. If the returns are similar (and they should be since it’s an index fund) you usually won’t go wrong purchasing the fund with the lowest fees.
Note – This article is based on a comparison of open-end no-load mutual funds with ETFs. Mutual funds with sales commissions or closed funds may charge higher fees or may be more risky than open-end no-load funds. If you’re interested in closed-end funds or your advisor recommends a load mutual fund, research them to fully understand these investment choices.