One of the more intimidating barriers of investing is learning the terminology. One common question I get is what is the difference between mutual funds and exchange traded funds (ETFs)? Does it matter which one I invest in? Most people have heard of mutual funds, but ETFs are a relatively new term.
Not to be dismayed! Today, we’re breaking down those barriers. We’ll discuss how these two types of funds work, their similarities, their differences, and why I generally prefer to use one over the other.
Disney World vs Disney Land
As a kid, there was no greater possible destination in the world than Disney World!
In fact, when I was 7 years old, my grandparents took me and my brother, Josh, to Disney World. I vividly remember riding all the iconic rides: Dumbo, Pirates of the Caribbean, Peter Pan, and even my grandma’s favorite (but certainly not mine), It’s a Small World. We would come back to the hotel each night, watch Peter Pan, and promptly reenact the fighting scenes using our newly-acquired plastic swords and popsicle sticks. Good times!
It wasn’t until I was a bit older that I discovered that Disney World isn’t the only magical place on earth. Growing up on the east coast, I was completely oblivious to the fact that Disney Land even existed!
Funny enough, my wife had the opposite experience. She grew up in Southern California and had visited Disney Land around the same age. Like me, she was blissfully unaware that another park name Disney World even existed!
Both parks are owned by the same company, have the same costumed characters, the same themes, and the same astronomical prices. But they’re not identical!
Disney World and Disney Land provide a good analogy for our topic today: there are so many similarities that people sometimes assume they are the same thing, but there are some key differences.
So let’s walk through a side-by-side comparison of these 2 types of funds…
Mutual Funds and ETFs: The Similarities
We’ll start with the similarities.
1. Mutual funds and ETFs allow investors to pool their money together in order to invest it (usually in stocks or bonds). Investors purchase shares in the larger pool of money. The money is managed by a fund company who decides what individual investments to purchase and distributes the fund’s earnings to the investors. This means that what's inside the fund (stock, bonds, etc.) is what drives the fund's performance and is therefore the most important factor. The mutual fund or ETF is simply a container that can hold different types of investments inside it.
Image source: Ramsey Solutions
2. Both types of funds are highly liquid, meaning it is easy to buy and sell shares. Unlike some investments that tie up your money for a period of months or years, investors are generally able to withdraw their money out of these funds within a matter of days.
3. The biggest benefit that mutual funds and ETFs provide to investors is diversification. Instead of buying hundreds of individual stocks and bonds yourself, you can invest in a fund that already does that. This way, you aren’t putting all your eggs in one basket.
Mutual Funds and ETFs: The Differences
There is a lot of overlap with these 2 types of funds. In fact, many companies offer the same exact fund as either a mutual fund or an ETF! This means both funds are invested in the exact same companies. The only difference is the “wrapper” used to bundle them.
I like to think of it as two fishing docks at opposite ends of a lake. It’s the same lake with the same fish, the key difference is how you are accessing it.
So why would it matter which one you use? Well here are some key differences:
1. Expense ratio plays a significant role in the comparison between mutual funds and ETFs. This ratio represents the fees charged by the fund company to cover expenses like management, administration, and marketing. Generally speaking, ETFs have lower expense ratios compared to mutual funds, making them a more cost-effective option.
2. The buying and selling process also varies between these funds. Mutual funds are bought directly from the fund company and are priced once per day. On the contrary, ETFs are bought and sold on an exchange throughout the trading day, offering real-time pricing and quicker transaction time.
Image source: Ramsey Solutions
3. Tax efficiency
is another crucial aspect when choosing between mutual funds and ETFs. Mutual funds often buy and sell individual securities inside the fund throughout the year. Whenever the fund sells an individual security for more than it purchased it for, this triggers a capital gain for the investor. This means that even if the fund was flat or lost money for the year, the investor might still owe capital gains at the end of the year.
By contrast, ETFs are generally more tax-friendly as they trigger capital gains when you buy or sell the ETF itself. This could allow investors to delay capital gains until further down the road.
4. Minimum investment requirements are different for mutual funds and ETFs. For ETFs the minimum is typically the price of one share, but some mutual funds require minimums ranging from $250 to $3,000. This makes ETFs more accessible for smaller investments. (I should also note that some custodians allow you to buy fractional shares of ETFs essentially eliminating any minimum investment amount).
Conclusion
ETFs have been gaining popularity due to their lower costs, tax efficiency, and ease of access. This is the reason why I’ve preferred to primarily use ETFs at Financial Pathway.
Both mutual funds and ETFs have their advantages and disadvantages, and the best choice depends on your investment goals and preferences. Understanding the differences between these funds can help you make informed decisions and create a well-balanced portfolio that aligns with your financial objectives.
As always, before making any investment decisions, consider consulting a financial advisor to ensure your choices align with your unique financial situation and long-term goals. Happy investing!
Financial Pathway LLC is an Investment Advisor registered with the State of Florida. All views, expressions, and opinions included in this communication are subject to change. This communication is not intended as an offer or solicitation to buy, hold or sell any financial instrument or investment advisory services.