Become a better investor
Lesson in Course: ETFs and mutual funds (beginner, 5min )
Mutual funds and ETFs are two very common investments. What is the difference and how do we know which one to go with?
ETFs and mutual funds serve as great investment options for our portfolio.
Let's start by looking at the similarities.
ETFs and mutual funds are professionally managed investment funds that pool the money from many investors to create a portfolio. Each investor gets a share of the portfolio. Depending on the fund's strategy, there could be a wide variety of investments in the portfolio.
When we find a strategy we like, we can buy a share of the fund and rely on the professionals to monitor it daily on our behalf.
The managed services don't come free. Both products charge management fees based on the fund's assets under management (AUM). AUM is the total market value of the investments in a fund's portfolio.
The fund uses these fees to keep the lights on and pay employees. The fees are stated by the expense ratio as a percentage of the AUM. If a fund has an expense ratio of 0.5%, it will charge $5 annually for $1,000 invested in the fund. When we buy an ETF or mutual fund in our brokerage account, we should not expect a bill for these fees. Instead, the fees will be deducted from the value of our investments.
ETFs and mutual funds are easy investments to make. Once we find one that matches a strategy we want, we can purchase them through our brokerage.
These products give us access to investments we might not have otherwise been able to make. For example, some stock prices are more than an average person could afford. By pooling money from investors, the fund can buy the expensive investments for the portfolio. That way, when we buy a share of the fund, we essentially own a fraction of that investment.
Roommates splitting the rent of a house is a similar example. Individually they might not be able to afford the entire rent, and depending on the room size, the rent might be higher or lower.
Both fund types offer great diversification benefits by allowing us to invest in a broad pool of securities without having to buy them all ourselves.
Every fund has a mandate that specifies its investment focus – which can be either passively or actively managed.
Passively managed funds usually invest in securities that replicate a market index, belong to a similar business sector or industry, or fall within a range of market capitalizations (business sizes).
Actively managed funds have more flexibility in the securities they invest in and the strategy they pursue to maximize returns. Some investors with a passive investment strategy will include actively managed funds in their portfolios.
No matter our investment goals, there is probably a fund that fits what we are looking for – regardless of how broad or specialized it may be.
With so many options, investors can build a great portfolio with just a few different broad-based funds.
The primary difference between these two fund structures is liquidity – or, put simply, when you can invest (or withdraw) your money. Mutual funds typically allow investors to buy and sell their shares at the end of each business day, whereas ETFs are open for trading anytime during market hours. We can buy one share of an ETF at 10 am and sell it an hour later if we want.
The net asset value (NAV) is the price of the fund's shares we buy or sell. It's determined by dividing the market value of the fund's assets by the number of shares in the fund.
Mutual funds price their shares at the end of the day after the financial markets close. Therefore, we wouldn't know the exact amount that we'd get for them until the end of the day if we sold our shares during the day.
Conversely, the NAV of an ETF is typically quoted throughout the day – making it easy to determine the price of each share at a given moment. However, ETF shares can sometimes trade at premiums or discounts (usually small) to the fund's NAV because of fluctuations in supply and demand.
ETFs generally offer lower expense ratios because it's cheaper to replicate an index than to create the custom strategies provided by mutual funds. For two very similar strategies, the ETF is better because of lower fees.
ETFs can provide diversification and more liquidity for investors looking for flexibility in the timing of buying or selling investments, while mutual funds often offer custom strategies that ETFs don't.
For both fund types, the expense ratio is a key metric to evaluate before making an investment decision. A lower expense ratio means that, over time, you keep more money. Funds with higher expenses will need to consistently outperform their lower-cost peers, all else equal – something that has been very hard to achieve in the history of financial markets.
Both fund types are great ways for investors to achieve low-cost diversification.
The total market value of the investments in a fund's portfolio
A percentage of the AUM that a fund charges as a management fee
The price of a fund's shares determined by dividing the market value of the fund's assets by the number of shares in the fund