Exchange-Traded Funds and Mutual Funds, Explained

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by Advice Chaser
by Advice Chaser

A well-known reality of the stock market is that, while the market as a whole almost always trends up, individual stocks can easily plummet. Investors reduce their risk by investing in a large number of different stocks, as well as other investment products. But keeping a portfolio balanced is a difficult job. One solution is to buy into a fund instead. 

Both exchange-traded funds (ETFs) and mutual funds are bundles of products you can invest in. This can include stocks, bonds, commodities, real estate investment trusts, and more. Since the fund is built to be balanced or to track a key indicator, it’s less risky than individual stocks you pick yourself. But, of course, it is still based on stocks and therefore can’t be made risk-free.

A fund is like a basket of securities you can invest in at once.

Mutual Funds

Mutual funds are the older, more established option. Most are actively managed, with professionals picking and rebalancing the securities in the fund. However, index mutual funds are passively managed, reducing the fees to the consumer.

In a mutual fund, you can earn money in three ways. First, you may receive dividends. Second, when the fund sells a stock that has appreciated, you will receive your share of the capital gains. Finally, when the fund itself increases in net asset value (NAV), you’ve earned something—but you won’t realize those gains until you sell the fund.

You buy shares of a mutual fund directly from the fund itself, not from other investors. Likewise, you can sell them back to the fund whenever you wish. This makes them more liquid than some other investment vehicles.

Mutual funds come with fees, because they cost something to manage, especially if they’re actively managed. Consider the past performance of a fund to see if the fees tend to be worth it. A fund with high fees will lose you money unless its performance is very good.

Exchange-Traded Funds

Exchange-traded funds (ETFs) are the newer product on the market. Unlike mutual funds, you buy them from other investors. Most ETFs are passively managed, which means lower costs for you. But since outperforming the market is difficult even for professionals, they often do just as well, especially once you factor in their lower fees.

ETFs are also more tax-efficient, since they involve less buying and selling and thus fewer taxable events. If you’re investing in a taxable account, this may save you a significant amount in capital gains tax.

Finally, ETFs tend to ask for smaller minimum investments. Mutual funds may expect an initial investment of $1000 or more, while ETFs have none. All you’ll need is enough money to buy a single share—which may be as little as $50.

When Should You Consider Each?

ETFs are useful for investors who:

  • have only a small amount to invest
  • invest in a taxable account and want to minimize taxes
  • want to actively manage their own account, or
  • want to match rather than outperform the market.

Mutual funds are better for investors who:

  • invest in a tax-free retirement account,
  • hope to outperform the market through active management, or
  • want to invest in an undervalued part of the market, which may make it easier to beat the market.

Keep in mind that you may not be able to find both an ETF and an equivalent mutual fund for any need. Perhaps the specific mix you want to invest in is only available as a mutual fund. In that case, don’t get scared away by mutual funds’ downsides—they may not even be relevant to you. Just make sure the fees aren’t so large they take away the value of your investment.

Don’t Go It Alone

When you’re seriously investing, you need sound advice to make sure you pick the best options for you. Financial advisors study the market constantly and know the best possibilities. We can connect you with the right advisor for you with a quick phone call.

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