Your Guide to ETFs and Mutual Funds

Your Questions Answered

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Exchange-traded funds (ETFs) have become increasingly popular of late, although they've been around for about 25 years. Mutual funds have been available for much longer, with the first modern-type mutual fund dating back to 1924 with Massachusetts Investors Trust. Many investors embraced mutual funds for their high returns back in the '80s, but these days you'll hear ETFs touted as cheaper, better alternatives.

People often ask, is an ETF really better than a mutual fund? You'll get a different answer depending on who you ask, but once you understand the differences, you can form your own opinion based on which instrument fits your needs best. Each investment type has its own merits, and you can make an educated financial decision that will have a positive impact on your portfolio or investing strategy once you get to know them.

What Are ETFs and Mutual Funds?

You should understand how ETFs and mutual funds work before deciding on which better fits your portfolio. Exchange-traded funds (ETFs) follow indexes—up, down, and all around. But they act more like equity investments. Mutual funds allow a group of investors to pool their money and hire a portfolio manager.

Which Type of Fund Should I Pick?

When you have a better understanding of the two investments and how they function, it’s time to decide which is the right asset for you. Find out the perspectives from people advocating both sides of the investment coin.

Benefits

While considering the pros and cons of each type of investment, take note of a few benefits you'll gain regardless of which type of security you choose. You can use mutual funds as well as ETFs to buy up a wide group of stocks that fit even very specific investing criteria, or even a bond fund to add a conservative hedge to your overall portfolio.

Say you want to replicate the market, which is basically the S&P 500's return. You can buy either the Schwab S&P 500 mutual fund or the SPDR S&P 500 ETF. You don't need to buy shares in each company held in the S&P 500's basket of stocks.

Mutual funds and ETFs generally have low fees. In fact, mutual funds actually beat ETF fees in some cases, especially if you choose passively managed mutual funds such as those that replicate indexes.

You can fully diversify your investment portfolio with just a handful of either mutual funds or ETFs because you can buy either type of fund with holdings of domestic stocks, small- or large-cap stocks, market-replicating index funds, or international stocks and bond funds to hedge your domestic holdings.

Both fund types are advantageous, but mutual funds make more sense for dollar-cost average investing and don't trigger any brokerage commissions, while ETFs have no minimum investment and are more tax-efficient.

Drawbacks

Risk management is too important to ignore, so understand the disadvantages of both funds before you make them part of your investing arsenal. You can't trade mutual funds on an exchange, but you can buy and sell ETFs on an exchange as you would with individual stocks, although you'll pay fees and commissions for the privilege. You may also need to satisfy a minimum investment amount to buy into most mutual funds.

Investment Costs

Once you're familiar with the features of the different fund types, familiarizing yourself with their costs is the next step. A few factors affect the costs you'll pay for either investment, depending on which you choose and how often you want to buy shares:

  • Fund management and fees: If you choose to invest in mutual funds, you'll be able to keep fees low by selecting passively managed funds, such as ones that track indexes like the S&P 500 or Dow Jones Industrial Average. However, many mutual funds make claims of higher earnings that will beat the market, and these funds are actively traded by a portfolio manager or team, which means that you'll be on the hook for higher fees.
  • Commissions: Because of the way you purchase mutual funds and ETFs, the potential commissions you'll pay differ as well. If you want to invest a certain amount of money each month, in a strategy known as dollar-cost averaging, you'll pay less if you buy shares in a mutual fund because you can often buy the shares without having to pay any sales commissions or transaction fees. ETFs, on the other hand, are traded like stocks, and you will probably need to pay a commission each time you purchase or sell shares in your chosen ETF, which makes ETFs a poor candidate for dollar-cost averaging.

    Tax Implications

    The biggest question of all for many investors is how investing in ETFs and mutual funds affects their tax situation. Tax rates vary depending on the fund, as well as on where you invest and when you close your position.

    Knowing how each investment impacts your finances come tax time is important. If you're invested in an actively managed mutual fund, you'll definitely come out worse at tax time, because at year-end you'll have a bill for capital gains taxes on each sale the portfolio manager makes throughout the year, which could be a large number.

    The Bottom Line

    Whether ETFs or mutual funds are the better choice for you is always a case-by-case answer. You should always consult a financial professional such as a broker or financial adviser before making any trades. All investments have some risk, including ETFs and mutual funds. Conduct thorough research before you hit the market.

    The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.