An investor's portfolio may include stocks, bonds, and sectors with value or growth options, and investors commonly decide whether a mutual fundor exchange-traded fund (ETF)meets their financial goals.
Mutual funds and ETFs can hold portfolios of investments like stocks, bonds, or commodities. They both adhere to the same regulations, like what they can own or how much can be concentrated in one or a few holdings.
Key Takeaways
- Mutual funds and ETFs may hold stocks, bonds, or commodities.
- Both can track indexes, but ETFs tend to be more cost-effective and liquid since they trade on exchanges like shares of stock.
- Mutual funds can offer active management and greater regulatory oversight at a higher cost and only allow transactions once daily.
Choosing ETFs
Exchange-traded funds trade on exchanges just like common stocks. Most ETFs are index-tracking and aim to match the returns and price movements of an index, such as the , by assembling a portfolio that matches the index constituents.
Passive management generally makes ETFs cheaper than mutual funds with lower expenses than index-tracking mutual funds. Because buyers and sellers are doing business with one another, the managers have far less to do. The ETF providers want the price of the ETF to align as closely as possible to the net asset value of the index. To do this, they adjust the supply by creating new shares or redeeming old shares.
In Jan. 2024, the Securities and Exchange Commission(SEC) approvedthe firstspot marketbitcoinETFs listed on theNYSE Arca,Cboe BZX, andNasdaqexchanges.
Benefits of ETFs
- Buying and selling can occur at any point during a trading session at market pricing.
- ETFs are not priced at the end of the day.
- There’s no minimum holding period. This is especially relevant in the case of ETFs tracking international assets, where the price hasn’t yet been updated, but the U.S. market’s valuation of it has.
- ETFs can reflect the new market reality faster than mutual funds can.
- Investors in ETFs and mutual funds are taxed based on the gains and losses incurred within the portfolios. ETFs engage in less internal trading, and less trading creates fewer taxable events.
Investors only pay capital gains taxes when they sell ETF shares. By holding on to shares, investors delay paying taxes until shares are sold.
Mutual funds are commonly managed by financial institutions such as Vanguard, T. Rowe Price, and BlackRock, either directly or through a brokerage firm. The purchase of a mutual fund is executed at the net asset value of the fund based on its price at the market close.
When investors sell shares, the same process occurs, but in reverse. Some mutual funds assess a penalty of up to 2% of the shares’ value for selling early, typically sooner than 90 days after purchase.
Mutual funds can track indexes, but most are actively managed. Actively managed funds incur high costs for analysts, economic and industry research, company visits, and administration. That typically makes mutual funds more expensive to run—and for investors to own—than ETFs.
Benefits of Mutual Funds
- Mutual funds can be purchased in fractional shares or fixed dollar amounts.
- Minimum initial investments for mutual funds are a base dollar amount and not based on the fund's share price.
- Investors benefit from professional managers when the fund is actively managed.
When Does a Taxable Event Occur for an ETF?
For an all-ETF portfolio, the tax will generally be an issue only if and when investors sell their shares. Just like mutual funds, if an ETF pays dividends, those count as taxable income.
When Are Investors Liable for Gains Earned from a Mutual Fund?
Unless individuals invest through 401(k) or other tax-favored vehicles, mutual funds will distribute taxable gains to investors, even if they merely hold the shares.
What Is Meant by an Open-End or Closed-End Fund?
Mutual funds and ETFs are both open-ended. The number of outstanding shares can be adjusted up or down in response to supply and demand. A closed-end fund (CEF) does not continuously offer its shares for sale but instead sells a fixed number once.
The Bottom Line
ETFs and mutual funds are baskets of individual securities like stocks or bonds. Both offer exposure to a variety of asset classes. Investors can gain more diversification from a mutual fund or ETF than investing in a single stock or bond.
FAQs
Proponents of ETFs argue that they are more efficient than mutual funds because ETF investors generally bear their own trading costs. In a mutual fund, investors typically invest and redeem with cash, and any costs of trading due to cash flows are shared by all investors in the mutual fund.
What is the main difference between ETFs and mutual funds? ›
With a mutual fund, you buy and sell based on dollars, not market price or shares. And you can specify any dollar amount you want—down to the penny or as a nice round figure, like $3,000. With an ETF, you buy and sell based on market price—and you can only trade full shares.
What are some of the arguments for why an ETF is better than a mutual fund? ›
Key Takeaways. Many mutual funds are actively managed while most ETFs are passive investments that track the performance of a particular index. ETFs can be more tax-efficient than actively managed funds due to their lower turnover and fewer transactions that produce capital gains.
What is the main difference between ETFs and mutual funds Quizlet? ›
Unlike mutual funds, an ETF trades like a common stock on a stock exchange. ETFs experience price changes throughout the day as they are bought and sold. *ETFs typically have higher daily liquidity and lower fees than mutual fund shares, making them an attractive alternative for individual investors.
What are three disadvantages to owning an ETF over a mutual fund? ›
Disadvantages of ETFs
- Trading fees. Although ETFs are generally cheaper than other lower-risk investment options (such as mutual funds) they are not free. ...
- Operating expenses. ...
- Low trading volume. ...
- Tracking errors. ...
- The possibility of less diversification. ...
- Hidden risks. ...
- Lack of liquidity. ...
- Capital gains distributions.
As we covered earlier, infrequently traded ETFs could have wide bid/ask spreads, meaning the cost of trading shares of the ETF could be high. Mutual funds, by contrast, always trade without any bid-ask spreads.
What is the difference between ETF and fund of funds? ›
FoFs are actively managed funds while ETFs are considered to be passively managed funds. Hence the cost or the expense ratio is higher in the case of FoFs as compared to ETFs.
What investment has the highest return? ›
Key Takeaways
- The U.S. stock market is considered to offer the highest investment returns over time.
- Higher returns, however, come with higher risk.
- Stock prices typically are more volatile than bond prices.
- Stock prices over shorter time periods are more volatile than stock prices over longer time periods.
Performance of ETFs
| Schemes | Latest Price | Returns in % (as on Jun 06, 2024) |
|---|
| CPSE Exchange Traded Fund | 88.02 | 102.12 |
| Kotak PSU Bank ETF | 720.00 | 71.63 |
| Nippon ETF PSU Bank BeES | 80.28 | 71.52 |
| SBI - ETF Nifty Next 50 | 718.44 | 58.2 |
33 more rowsIf you're paying fees for a fund with a high expense ratio or paying too much in taxes each year because of undesired capital gains distributions, switching to ETFs is likely the right choice. If your current investment is in an indexed mutual fund, you can usually find an ETF that accomplishes the same thing.
Advantages of Mutual Funds. There are several specific reasons investors turn to mutual funds instead of managing their own portfolio directly. The primary reasons why an individual may choose to buy mutual funds instead of individual stocks are diversification, convenience, and lower costs.
What are the differences in the costs of mutual funds and ETFs? ›
ETFs have transparent and hidden fees as well—there are simply fewer of them, and they cost less. Mutual funds charge their shareholders for everything that goes on inside the fund, such as transaction fees, distribution charges, and transfer-agent costs.
What are the three key differences between index funds and mutual funds? ›
Index funds seek market-average returns, while active mutual funds try to outperform the market. Active mutual funds typically have higher fees than index funds. Index fund performance is relatively predictable; active mutual fund performance tends to be less so.
Which is safer ETF or mutual fund? ›
In terms of safety, neither the mutual fund nor the ETF is safer than the other due to its structure. Safety is determined by what the fund itself owns. Stocks are usually riskier than bonds, and corporate bonds come with somewhat more risk than U.S. government bonds.
How long should you hold an ETF? ›
Holding an ETF for longer than a year may get you a more favorable capital gains tax rate when you sell your investment.
Which is the safest mutual fund? ›
Top 10 Low Risk Mutual Funds to Buy in the Share Market in India...
- Bank of India Overnight Fund.
- Mirae Asset Overnight Fund.
- Axis Overnight Fund.
- Kotak Equity Arbitrage Fund.
- Tata Arbitrage Fund.
- Nippon India Arbitrage Fund.
- Axis Arbitrage Fund.
- Aditya Birla Sun Life Arbitrage Fund.
ETFs have transparent and hidden fees as well—there are simply fewer of them, and they cost less. Mutual funds charge their shareholders for everything that goes on inside the fund, such as transaction fees, distribution charges, and transfer-agent costs.
Do ETFs pay dividends? ›
If you own shares of an exchange-traded fund (ETF), you may receive distributions in the form of dividends. These may be paid monthly or at some other interval, depending on the ETF. It's important to know that not all dividends are treated the same from a tax perspective.
How does ETF work? ›
ETFs combine the range of a diversified portfolio with the simplicity of trading a single stock. Investors can purchase ETF shares on margin, short sell shares, or hold for the long term. ETFs can be bought / sold easily like any other stock on the exchange through terminals across the country.
