Part of my journey to greater financial wellbeing is applying what I know from my work at iShares to my own investments.
One of the questions I get all the time at work is how mutual funds and ETFs differ, and how to pick between them. It also happens to be a topic I need to re-visit for my personal portfolio.
A quick primer, by way of context: Both ETFs and mutual funds are baskets of securities (stocks, bonds or both, depending on the fund). Because they offer multiple securities in one fell swoop, they’re both well-known for their diversification benefits.
A few key ways in which they differ (and considerations for your own approach):
- How they trade. ETFs are listed on stock exchanges and trade throughout the day, just like Johnson & Johnson, Apple, Exxon or any other stock. Mutual funds, on the other hand, are accessed directly from fund companies, and are traded only once daily at the end of the trading day—at a price that is determined when the markets close that day.Does that really matter? It depends. Sometimes investors want the flexibility of being able to get in and out of the market quickly (like in 2008 when the market crashed and people wanted out ASAP). Sometimes, it doesn’t matter as much. With that said, many long-term investors who aren’t trading daily still like ETFs because they can get in and out easily if they need to.
- Tax implications. ETFs are generally more tax-efficient than mutual funds. Why? Here’s a simple explanation:On the exchange, ETF buyers and sellers meet and trade dollars for shares and vice versa. Just like with any stock, when you sell your ETF you’re subject to capital gains taxes if your shares appreciated in value since you bought them.If you sell your traditional mutual fund at a gain, you’re subject to the same tax dynamics. But when you go to the mutual fund company to exchange your shares for dollars, the fund may need to sell securities to generate cash to meet your redemption. If the fund has to sell these securities at a gain, it may recognize capital gains of its own. Those capital gains are passed down to fund shareholders, whether you sold your shares or not.This doesn’t mean that all ETFs are tax efficient and all mutual funds are not. It’s important to check your fund’s track record and select a fund manager who prioritizes tax efficiency, so you can keep more of what you earn.
- What they cost.Both ETFs and mutual funds charge an expense ratio, which covers the cost of managing the fund. Expense ratios can vary, but a general rule of thumb is that ETFs and index-based mutual funds tend to be less expensive than active mutual funds. This is because index fund managers try to create a portfolio that looks and performs as close to an index as possible, while active fund managers “actively” try to outperform. The higher expense ratio reflects that you’re paying someone to actively buy and sell securities on your behalf.Because ETFs trade on an exchange, you may incur transaction costs (a commission, for example) for executing your order. On the other hand, mutual funds may charge sales loads or redemption fees. Check out your fund’s prospectus or website for a full list of potential charges.
Now, this isn’t an exhaustive list of the differences between mutual funds and ETFs—see here for more.
So which one is better, ETFs or mutual funds? Trick question! The answer is that they’re both good tools, and could both have a place in your portfolio.
The key is to pick the vehicle that’s best for your investment goals. Rather than choosing an active or index strategy based on any one of the factors above, you should understand how the two strategies differ and pick the one that makes sense for you.