If you’ve been looking to broaden your investment portfolio, you may have heard the terms mutual funds and exchange-traded funds thrown around. Not sure what the differences are? You’re not alone — according to a 2018 study from Raymond James, around 17 percent of investors aren’t sure what differentiates the two.
While mutual funds and ETFs are both sound options for investors, the differences between them can help you decide where your interests are better served.
What do mutual funds and ETFs have in common?
Mutual funds and exchange-traded funds are both commonly referred to as baskets because they carry a varied mix of securities including stocks and bonds. Barclay Palmer writes for Investopedia that mutual funds and ETFs are examples of pooled fund investing, offering multiple investors the benefits of a diversified portfolio.
What are the key differences?
Despite broadly functioning in a similar fashion and sharing a common purpose, mutual funds and ETFs have notable differences that can make one a better option for your needs than another.
When you purchase mutual funds through a company like Fidelity or Vanguard, you’ll have the benefit of active fund management compliments of the company’s financial experts. According to The Motley Fool contributor Adam Levy, these experts allow a mutual fund the opportunity to outperform other funds that use passive management, earning you a larger return. By the same stroke, this can also leave actively managed mutual funds to underperformance. ETFs widely use passive management, which consistently tracks an index like the S&P 500.
With active management comes the additional cost of utilizing expert insights. Ellen Chang, writing for U.S. News & World Report, notes that actively managed mutual funds tend to carry a higher cost, otherwise known as an expense ratio. ETFs that use passive management can carry expense ratios around half the rate of an actively managed mutual fund. Mutual funds also carry higher fees.
Cathy Pareto of Investopedia notes that you’ll have a higher minimum mandatory investment with mutual funds. One of the major examples, the Vanguard 500 Index Investor Fund, requires a $3,000 investment. With EFTs, you can invest as much or as little as you wish.
O’Brien also points out that mutual funds may require you to pay taxes on your profits if you keep the money in a taxable account. If you deposit your profits into a tax-deferred retirement account, you won’t have to worry about taxes until retirement. O’Brien notes that ETFs typically don’t carry capital gains tax burdens.
Because exchange-traded funds follow market index rates, you can buy and sell them as freely as you would stocks. Sarah O’Brien, writing for CNBC, notes that this will give you the ability to adapt to a day’s news and purchase ETFs at moments of opportunity. With mutual funds, you are only able to buy and sell once per day after market closing at 4 p.m.
Both mutual funds and exchange-traded funds are viable options if you’re looking to grow a successful investment portfolio. Speak with your financial advisor about your goals and ambitions to learn which might be the best for your situation.
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