Differences Between Mutual Funds and ETFs

How Mutual Funds and ETFs are Different

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What are the differences between ETFs and mutual funds?. Getty Images

There are fundamental differences between mutual funds and ETFs that investors need to know before investing. They each have their advantages and disadvantages. Perhaps most importantly, mutual funds and ETFs can be used in combination to build a solid portfolio.

Similarities of Mutual Funds and ETFs

Before going over differences, here is a quick summary of similarities: Both mutual funds and ETFs enable investors to buy a basket of securities within one investment security.

They both typically invest within a stated or implied objective, such as growth, value or income, and they will usually invest within a certain category of stocks or bonds, such as large-cap stocks, foreign stocks, or intermediate-term bonds.

Most ETFs are passively-managed, which makes them most similar to index mutual funds. Within this similarity, both the index fund and the ETF will mirror the performance of an underlying index, such as the S&P 500; they both have extremely low expense ratios compared to actively-managed funds; and they both can be prudent investment types for diversification and portfolio construction.

Differences Between Mutual Funds and ETFs

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The primary difference between mutual funds and ETFs is the way they trade (how investors can buy and sell shares). What does this mean? For example, let's say you want to buy or sell a mutual fund. The price at which you buy or sell isn't really a price; it's the Net Asset Value, or NAV, of the underlying securities; and you will trade at the fund's NAV at end of the trading day.

Therefore, if stock prices rise or fall during the day, you have no control over the timing of execution of the trade. For better or worse, you get what you get at the end of the day with mutual funds.

In contrast, ETFs trade intra-day. This can be an advantage if you are able to take advantage of price movements that occur during the day.

The key word here is IF. For example, if you believe the market is moving higher during the day and you want to take advantage of that trend, you can buy an ETF early in the trading day and capture it's positive movement. On some days the market can move higher or lower by as much as 1.00% or more. This presents both risk and opportunity, depending upon your accuracy in predicting the trend.

Part of the trade-able aspect of ETFs is what is called the "spread," which is the difference between the bid and ask price of a security. However, to put it simply, the biggest risk here is with ETFs that are not widely traded, where spreads can be wider and not favorable for individual investors. Therefore look for broadly traded index ETFs, such as SPDR S&P 500 (SPY) or iShares Core S&P 500 Index (IVV) and beware of niche areas such as narrowly traded sector funds and country funds.

Another distinction ETFs have in relation to their stock-like trading aspect is the ability to place stock orders, which can help overcome some of the behavioral and pricing risks of day trading. For example, with a limit order, the investor can choose a price at which a trade is executed. With a stop order, the investor can choose a price below the current price and prevent a loss below that chosen price.

Investors do not have this type of flexible control with mutual funds.

ETFs typically have lower expense ratios than most mutual funds and can sometimes have expenses lower than index mutual funds. This can in theory provide a slight edge in returns over index funds for the investor. However ETFs can have higher trading costs. For example, let's say you have a brokerage account at Vanguard Investments. If you want to trade an iShares ETF, you may pay a trading fee of around $7.00, whereas a Vanguard index fund tracking the same index can have no transaction fee or commission.

Should You Use Index Funds, ETFs or Both?

The index funds vs ETF debate is not really an either/or question. Investors are wise to consider both. Fees and expenses are the enemy of the index investor. Therefore the first consideration when choosing between the two is the expense ratio. Secondly, there may be some investment types that one fund may have an advantage over the other. For example, an investor wanting to buy an index that closely mirrors the price movement of gold, will likely achieve their goal best by using the ETF called SPDR Gold Shares (GLD).

And while past performance is no guarantee of future results, historic returns can reveal an index fund or ETF's ability to closely track the underlying index and thus provide the investor greater potential returns in the future. For example the index fund, Vanguard Total Bond Market Index Inv (VBMFX) has historically outperformed iShares Core Total US Bond Market Index ETF (AGG), although VBMFX has an expense ratio of 0.20% and AGG's is 0.08% and both track the same index, the Barclay's Aggregate Bond Index. In different words AGG performance has historically trended further below the index than VBMFX.

Finally, for building a diversified portfolio, mutual funds and ETFs can be complimentary or each other. For example, some investors like to use ETFs for sector funds and mutual funds for actively-managed choices. Either way you decide, just be sure the mix is diversified and is suitable for your risk tolerance and investment objectives.

Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.