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There are two ways to invest in stocks or bonds.
- Buy individual stocks or bonds
- Invest in a group of stocks and bonds through what are known as ETFs (exchange traded funds) or mutual funds
While you can go out and pick individual stocks, the best investing strategy is to diversify your investments by investing in many different companies.
You don’t want to have all of your money in one stock in case that company goes out of business.
The easiest way to diversify your investments is to buy mutual funds or ETFs.
ETFs and Mutual Funds are both ways to invest in a bunch of company stocks at one time and a way to reduce the risk of just investing in individual companies.
Let’s dive into the differences.
Guide to ETFs and Mutual Funds:
What are ETFs and Mutual Funds?
Both ETFs and Mutual Funds are investment vehicles that invest in a selection of stocks organized around a particular theme – like healthcare, energy, or even the entire stock market.
Some of the most popular ETFs and mutual funds invest in most of the stock market, which allows them to distribute the risk across the entire stock index.
Both ETFs and mutual funds are designed for diversification, which is accomplished by holding a collection of stocks, bonds, or a mixture of both (in what are known as blended funds).
This is the value of ETFs and mutual funds – that you don’t have to buy a bunch of stocks separately and you can invest in a large group of stocks easily and efficiently.
In theory, investing in a large group of stocks creates more diversification (an essential element of successful investing) and can often mitigate some of the volatility associated with only owning a smaller portfolio of individual stocks.
Mutual Funds vs. ETF
So what are the differences and which one should you choose?
Purchasing + Fees
ETFs and mutual funds can be bought directly by consumers from an investment management company with little to no purchase fee – however there is an annual fee for any investment which for most ETFs and mutuals funds is typically a percentage of assets under management between 0.05% – 1% (so the fee is taken out directly from your investments).
Unlike individual stocks, ETFs and mutual funds are typically less risky because they are more diversified (comprised of a bundle of stocks rather than just one specific stock).
Both ETFs and Mutual Funds can contain stocks as well as bonds.
Since “active” Mutual Funds are managed by outside companies they can lack transparency as to which stocks actually comprise the fund on a daily basis, this clouds transparency and can create an overlap in investment and surprise when it comes to paying taxes on capital gains.
ETFs are traded directly and allow a clear view of the stocks that are being purchased that are a part of that ETF.
ETFs like stocks can be traded any time of day.
Mutual Funds can only be traded at the end of the day after the market closes, this prevents an investor from setting a market limit on buying or selling the fund and locks the investor to the market price for that specific day.
ETFs, unlike Mutual Funds, can be traded directly online just like a stock.
Mutual Funds typically have a minimum limit that has to be met and often charge an annual fee if the investment falls below the allowable.
Institutional class funds and hedge funds for example require minimums of $1million or more. Other minimum requirements range from $500-$3000 and vary depending on the type of fund it is, IRA for example or college funds.
There are of course Mutual Funds with low minimums but they are harder to come by and do need to be researched. ETFs unlike mutual funds do not have minimums and can be acquired with as many or as little shares as one prefers.
Because of this it also allows an investor to further reduce the risk by investing in multiple ETFs rather than one ETF or Mutual Fund.
Unlike the complex structure of most mutual funds, ETFs are much simpler and it is easier to pay capital gains tax on them.
Since investors have little control and transparency over actively managed Mutual Funds one can still owe taxes though the fund did not produce any gains that year, this is due to the fact that fund managers have the ability to trade individual winning stocks that year causing the investor to owe taxes on the gains from such trades while the overall fund shows a loss.
With ETFs since the investor has control and transparency, he/she can decide when it is best to cut their losses short (or harvest losses) and at the end of the year so there are no surprises.
To make it even simpler, with ETFs if there are no gains there are no taxes to be paid, with Mutual Funds this is not always the case, even when the entire fund is at a loss an investor may have to pay taxes.
Active vs. Passive Management
The stocks that make up an ETF or mutual fund are either chosen when the fund is created and updated very infrequently (passively managed) or the stocks inside the fund are chosen more frequently by bankers (actively managed).
A Quick FYI – actively managed funds generally have higher management fees than passively managed funds because they take more work for the fund company to manage.
All ETFs and mutual funds typically have a common theme – for example a fund like the Vanguard Total Stock Market Index Fund invests in a large portion of the US stock market (so you can own a lot of the stocks in the stock market without having to buy them individually).
The top 5 holdings in this Vanguard stock fund are:
- Johnson & Johnson
…so you are able to invest in these companies just by being in this fund. It is worth noting that the Vanguard Total Stock Market Index Fund is available as both a mutual fund and an ETF.
There are also newer “trendy” funds popping up on Wall Street all the time that invest in different industries – like healthcare, consumer staples, and everything under the sun. Seriously just some quick searching and you will find mutual funds and ETFs for pretty much anything you can imagine.
As more pressure has been put on Wall Street to generate growing profits amidst increasing investor skepticism they continue to develop new ETFs and mutual funds to invest in. Just check out some of the industry funds on Morningstar – the top mutual fund rating company in the world.
There are a ton and most of them aren’t great investments – both because they don’t have proven track records and they are likely going to end up being riskier and more expensive than other investment options. Sure you could invest in healthcare stocks like the Vanguard Health Care Fund which has generated an insane 24%+ return over the past 3 years, but this still limits your exposure to just healthcare stocks.
With the right portfolio however funds like this might make sense for some added diversification, but for me personally the core of my own investments are in low cost total market index funds that track the entire stock market instead of individual sectors (which likely are more risky over the long term).
ETF or Mutual Funds, Which is For YOU?
When comparing Mutual Funds with ETFs it is clear that ETFs win out due to a couple of different factors:
- Direct Management Availability
- Fund Transparency
- Trading Flexibility
- Lower Fees
- Tax Expectations
Demand for ETFs has grown substantially. According to Charles Schwab 2015 ETFs Investor study, 34% of participants stated that ETFs will be their core investment in the future and 31% plan to increase their ETFs holdings in the next year.