When building out an investment portfolio, investors have many options at hand, including stocks, mutual funds and exchange traded funds.
While many are familiar with stocks and mutual funds, ETFs are relatively new to the investment world.
To start off, open-end mutual funds are backed by a group of investors who pool their money and a manager would invest that cash pool according to a specific strategy or track a certain index, according to The Motley Fool.
ETFs, like mutual funds, allow an investor to gain diversified exposure to a group of securities through one single investment. However, there are some key differences. For instance, investors can buy and sell ETF shares throughout the trading day, like an ordinary stock, on a brokerage account. Additionally, the majority of the ETF universe is comprised of passive, index-based offerings – there are only 130 actively managed ETFs of 1,754 U.S.-listed ETFs on the market.
Investors would pick a mutual fund or ETF over an individual stock for diversification purposes. An investor may invest all of his or her money in a single stock, but one’s wealth would be tied to the outlook of that single company. With a fund, an investor may access broader markets as many ETFs include exposure to hundreds if not thousands of various company stocks. However, ETF investors may not enjoy the same level of upside potential since ETFs will hold various components with varying performances.
Commission fees are also a consideration when filling out an investment portfolio. If an individual were to diversify with a basket of various stocks, commission fees could add up. Funds provide an easy access point to a diversified portfolio, but mutual funds also come with minimum investments. ETFs do not have minimum investment fees, but they also incur trading commissions like stocks – some brokerage platforms, though, offer commission-free trades on ETFs. [Assessing the Total Cost of ETF Ownership: A Real World Example]
With funds, investors will also be exposed to fund fees or the expense ratio that pay for operating the fund. Mutual funds typically come with higher fees of over 1% in annual expenses as many are actively managed. On the other hand, index-based ETFs come with much cheaper fees, with the cheapest ones showing a 0.04% expense ratio.
Moreover, the ETF structure is touted as a tax-friendly investment vehicle since investors do not have to pay taxes on capital gains until they sell the position. In contrast, mutual funds incur capital gains spread among all fund’s investors, and the funds may even issue a capital gains tax bill during losing years if the fund is forced to sell positions to raise cash. [How ETFs Are Traded]
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.