We currently have more opportunities to invest in different types of securities than ever before. Two popular investment options are mutual funds and exchange-traded funds (ETFs).
The two are similar in most aspects, but the differences are important when selecting the investment option that’s best for you.
What Mutual Funds and ETFs Have in Common
Mutual funds and ETFs can consist of stocks, bonds, commodities, assets, or even other mutual funds and ETFs. Both allow you to instantly diversify your investments at a lower cost than investing in each of those assets individually.
Each mutual fund and ETF has a specific theme. Some are designed to mimic an index, such as the S&P 500 or Dow Jones Industrial Average. These are called index funds, and can take the form of mutual funds or ETFs. Others invest in industries, like pharmaceuticals, energy or precious metals.
Some funds focus on companies from a specific geography, such as emerging market funds or funds that invest in companies from a single country. There is even a fund that only invests in “sin stocks” in the alcohol, tobacco, firearms and defense industries. The possibilities are endless and are at the discretion of the managers in charge of the fund.
How ETFs and Mutual Funds Differ
While mutual funds and ETFs behave similarly, there are some important differences to be aware of.
Mutual funds and ETFs can both be bought and sold through nearly any brokerage, but the purchase and sale process works differently. Mutual fund trade orders can be entered at any time, but the transaction always takes place at the end of the trading day when the fund price is calculated. You can buy and sell mutual funds in specific dollar amounts, even if that means buying or selling a small fraction of a share.
ETFs are bought and sold like stocks, and trade on the same stock exchanges. The prices are instantly updated throughout the day and most orders execute immediately based on liquidity. Unlike mutual funds, ETFs can be bought in the morning and sold in the afternoon.
Because of the nature of ETFs, there are rarely any rules about how long you have to hold the fund before you can sell. However, there are rules that dictate how long you have to hold a mutual fund before you can sell it without paying a fee.
A good rule to follow is that mutual funds are best for long-term investments, while ETFs work for either long-term or short-term investments.
Mutual Fund and ETF Fees
When you buy or sell a stock, you generally pay a fee. Funds have these fees too, but can also charge additional management, marketing and load fees.
Management and marketing fees pay the fund manager salaries and operating expenses. Load fees can be charged by funds at the time you buy and sell. These fees are common, but two similar funds can have different fee structures.
Some low-cost index funds can have fees less than 0.25% per year, while some high-expense mutual funds charge over 4% annually. These fees can completely wipe out any investment gains you make, or significantly lower them. However, depending on your brokerage, some fees might be waived.
For example, if you invest through Charles Schwab, you only have to pay the annual management fees. The same goes at other large brokerages with their own fund families such as Fidelity and Vanguard. But remember, just because a fund trades fee-free does not make it a better-performing fund.
Beware False Diversification
Many investors believe that investing in a mutual fund or ETF gives them instant diversification. That is true in many cases, but not in all.
If you buy an S&P 500 index fund, you are investing in the 500 companies listed on the S&P 500. If one specific industry performs poorly, but others do well, your investment value could increase. However, if you buy an industry-specific fund and that industry goes through a rough patch, your entire fund will suffer.
If you buy a diversified fund, your investments will follow the market as a whole. If you invest in a niche fund, you will gain diversification within the industry, but not in your overall investments.
Are Mutual Funds or ETFs Right for You?
No two investors are exactly alike, so it is up to you to decide whether mutual funds or ETFs better meet your needs. In some situations, an investment company offers the exact same investment through both a mutual fund and an ETF. Short-term versus long-term goals will influence your decision on which to buy, along with available funds.
Many investors prefer one over the other, but it is common for people to invest in both mutual funds and ETFs at the same time to create a combination of investments that match their investment goals.
When you are ready to invest in a fund, do your homework to pick the right choice. Look at historic performance, fees and your goals to decide which is right for you.
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