United States: Mutual Funds Or ETFS? Understand The Differences Before You Choose

Last Updated: August 17 2016
Article by Dan Newman

Mutual funds have been around for nearly a century. Exchange-traded funds, or ETFs, are the newer kid on the block. The two investment types have much in common, but also have important differences that make each more appropriate for certain situations.

Passive or Active

ETFs have quickly assumed a prominent place on the U.S. investment landscape. In late 2014, more than $2 trillion in net assets were held in 1,400 ETFs, up from a single offering in 1993 and fewer than 100 in 2002. Despite this growth, mutual funds remain dominant. According to the Investment Company Institute, there are nearly $16 trillion of assets owned across about 8,000 mutual funds.

There are two basic types of mutual funds: actively managed and index-based. With actively managed funds, a portfolio manager decides which securities to buy and sell to give the fund the best opportunity to outperform a benchmark index. Index funds, however, are passively managed, meaning they are designed to replicate a benchmark's characteristics and match its performance.

Despite a small number of actively managed ETFs, the vast majority are passive investments. They are designed to track a particular benchmark, making them most similar to index mutual funds.

Differences in Pricing

Even though index funds and ETFs share many characteristics, they also have significant differences. For starters, investors in mutual funds generally buy and sell shares directly from a fund company. The shares are priced once per trading day after the close of trading and investors must buy before then to receive that day's price.

ETF shares, in contrast, are transacted on stock exchanges via a brokerage account. Their prices fluctuate throughout the day based on supply and demand. This means that shares sometimes temporarily trade at a premium or discount to their underlying investment's net asset value (NAV). If the gap between share price and NAV gets too wide, buyers or sellers theoretically emerge to bring the prices back in line. However, in practice, the price discrepancy can persist for days or even longer.

Another key difference is that, just as with stock trades, investors incur brokerage commissions each time they buy and sell ETFs. Thus, the more frequently you transact, the higher your cost of ownership. Buying mutual fund shares directly from a fund company is usually commission-free (although some funds do have sales charges or "loads").

Because most ETFs are passively managed, they tend to have low expenses, especially compared with actively managed mutual funds. Index mutual funds also generally have low expenses.

Tax Treatment Varies

Most ETFs are tax efficient, especially compared to actively managed mutual funds, because they are not required to make distributions. ETFs are also typically more tax efficient than index mutual funds.

When index funds need to redeem shares, portfolio managers may have to sell stock to generate cash. This can create capital gains that are passed through to individual shareholders, even those who never sell their own fund holdings. Because ETFs are transacted privately between buyers and sellers, investors have significantly more control over their taxes.

However, it is important to note that, if you own mutual funds in a tax-advantaged retirement account, such as an IRA, your purchases and sales do not involve capital gains. Further, fund distributions do not result in tax.

Consider Your Goals

Both mutual funds and ETFs can help you achieve your investment objectives. However, both also carry risks, including the risk that they will decline in value and you will lose money that you have invested in them. Discuss your goals and risk tolerance with your financial advisor and he or she can help guide you on the most appropriate investment.

Sidebar: Consider Your Objectives

Your individual situation will determine whether you are best suited for an exchange-traded fund (ETF) or a traditional mutual fund.

If you want a chance to beat the market (by, for example, outperforming the S&P 500 index), you will probably want to consider an actively managed mutual fund. Of course, despite their best intentions, many active managers wind up trailing their benchmark because of higher expenses and other factors.

It is important to think about your investment goals and timing. If you plan to make small, regular investments for a long-term objective, you might be better off setting up an automatic investment plan with a mutual fund company. That way, your frequent purchases will be free of transaction costs. ETFs, meanwhile, may be more cost effective if you are making a larger, one-time investment.

Consider the investment objectives, risks and charges and expenses of mutual funds carefully before investing. For this and other information about the mutual funds you are considering, please read the prospectus carefully before investing. Mutual fund investment values will fluctuate and shares, when redeemed, may be worth more or less than original cost.

ETFs do not sell individual shares directly to investors and only issue their shares in large blocks. ETFs are subject to risks similar to those of stocks. Consider the investment objectives, risks and charges and expenses of ETFs carefully before investing. Investment returns will fluctuate and are subject to market volatility, so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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