Previously on our beginner’s investment guide blog post, we compared two of the most common terms in the investing world, stocks and bonds. Now on to something a bit more challenging……………………ETFs vs. mutual funds.
People often use the words ETFs and mutual funds interchangeably, which is very much incorrect. It’s important to distinguish the difference between the two. Both have similarities, but the differences are glaring, yet vital to know in order to capitalize on your investment opportunities.
In this week’s post, we’re going to discuss how ETFs and mutual funds are similar, how they differ, and my preferred ways to invest each.
How They’re Similar
The mutual fund has long reined king of the stock market since its first fund in 1924, until now. With the creation of the first ETF in 1993, mutual funds have a new competitor in the stock market landscape.
First off, what does ETF stand for exactly? Exchange Traded Fund, and yes, an ETF is a fund just as is a mutual fund.
Both ETFs and mutual funds represent professionally managed groups of stocks or bonds into one single fund. Both are managed by a group of people designed to keep the alignment of the fund’s portfolio as intended for a fee, some more costly than others.
Both ETFs and mutual funds are less risky to own, compared to owning individual stocks or bonds. To match the diversification of funds by buying and selling individual stocks or bonds would take a tremendous amount of knowledge, time, and energy. It’s actually not possible to keep up with unless you do this sort of thing for a living.
How They’re Different
Now for the glaring differences. There are many, so get ready.
First off, ETFs can be traded just like an individual stock or bond during a major stock exchange, while, mutual funds can only be bought or sold at the end of the day when they are priced. This offers ETFs much more flexibility in terms of when you want to enter or exit the stock market. However, this also gives people an incentive to day trade ETFs just like any stock or bond. Not necessarily a good tactic in my opinion.
ETFs have a much lower cost to enter compared to mutual funds. I believe this is the main reason they’ve become so incredibly common for newbie investors at younger ages. ETFs are bought and sold, just like stocks, by purchasing shares during the stock market exchange. On the other hand, the majority of mutual funds require a minimum purchase of around $2,000-3,000 worth of shares to invest in that specific mutual fund.
On average, ETFs are “cheaper to own” compared to most mutual funds, and for a few reasons:
One, ETFs offer more and more commission free and lower expense ratio options. This, along with the fact that you can buy and sell ETFs like stocks, allows another incentive to day trade ETFs. (Commission free meaning it doesn’t cost you a dime to buy or sell your shares, and the expense ratio covers management and advertisement fees associated with the fund.) Since most mutual funds aim at beating the market, but rarely do, their expense ratios are typically higher and have a standard commission fee involved with the fund.
Secondly, ETFs on average are more tax efficient than most mutual funds. This topic can get very detailed, so I’ll do my best to cover it. Any capital gains made on a retirement account (a.k.a. 401(k) or IRA) succumb to an income tax. The difference in how ETF’s and mutual fund’s capital gains are taxed boils down to the difference in each fund’s structure and the way they are traded. With less portfolio turnover within a fund, fewer taxable events occur. Mutual funds have higher turnover rates within their funds compared to ETFs, thus are less tax efficient than the majority of ETFs.
If you had to invest now, and only had to choose between ETFs or mutual funds, you might think, “No brainer, ETFs all the way.”
Not so fast. Remember, most of this is information is based on averages. ETFs and mutual funds should ONLY be compared on an individual level. Both funds are too multifaceted to claim that, in general, ETFs are better than mutual funds. It will always be a case by case scenario.
How I Recommend You Invest
The biggest problem I have with ETFs is that they incentivize day trading. With a low cost to enter, an increase in commission free trading, and it’s trading flexibility easily traps uneducated investors into buying and selling ETFs as if they are individual stocks. You’ll end up losing in the long run, or not gaining as optimal as you could have.
I’ll give mutual funds some credit where credit is due. At least mutual funds were never designed for day trading. They were always meant for buy and hold investments. If you constantly buy and sell mutual funds, you’re wasting tons of money on commission and broker fees. When buying and holding, you need to keep an eye on the expense ratio. High expense ratios compounded over the years adds up to tons of money given away to fund managers that rarely outperform the market.
In my personal opinion (and this is what I do), a quality ETF and mutual fund should be invested the exact same way. And by quality, I mean a fund that follows the market or mimics an index with low expense ratios, less than 0.1%. Buy and hold funds for long periods of time, whether in your 401(k), Roth IRA, or brokerage accounts.
Hope you all enjoyed this week’s beginner investment guide blog post! If you’ve missed our previous investment blog post comparing stocks and bonds, click here! I highly suggest educating yourself on these two terms. ETFs are becoming more common in employer retirement programs, meaning everyone will eventually run across an ETF sooner or later.
“Invest for the long haul. Don’t get too greedy and don’t get too scared.”
Book of the Month: “Extreme Ownership: How U.S. Navy Seals Lead and Win” by Jocko Willink and Leif Babin