How to Choose Between Mutual Funds and ETFs

How to Choose Between Mutual Funds and ETFs

May 23, 2020
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If you're looking to invest in a blend of companies rather than individual stocks, both mutual funds and ETFs are worth considering.

With so many asset classes available to invest in, it can be hard trying to decide what’s best for your long-term and short-term investing goals. Mutual Funds and Exchange Traded Funds (ETFs) are often in competition with one another, fighting for a spot in the portfolios of investors.

Both Provide Portfolio Diversification

Mutual funds and ETFs (Exchange Traded Funds) have a lot in common, and there’s a reason why many investors get hung up on deciding between the two. Both of these investment types contain a nice mix of a bunch of different assets – which means they’re both a great way for investors to diversify their portfolios.

The key difference comes in how they are managed. Mutual funds can only be purchased at the end of the trading day and their prices are calculated based on how the day went. ETFs, on the other hand, can be traded just like stocks can on the stock market, bought and sold in real-time during market trading hours.

Active vs. Passive Asset Management

So if each of these investment types have a bunch of different assets and securities bundled up inside of them, how are they managed? The answer to that question shows another key difference between mutual funds and ETFs.

The assets inside of a mutual fund are actively managed. These assets are constantly bought and sold by the appointed manager, whose job it is to ensure the fund achieves its goals despite changes in market conditions.

Because mutual funds are actively managed, they have higher fees and expense ratios. ETFs are more passively managed because they typically just track a certain market index, so there is very little management involved – which results in lower costs.

Who should consider investing in ETFs?

  • **Do you want to actively trade ETFs like you would stocks? **ETFs allow intraday stock trading such as limit orders, stop orders, and even short selling. You can’t do that with mutual funds.
  • Do you want niche-focused trading? ETFs focus on specific industries or commodities and can give you exposure to very specific, niche markets.
  • Are you looking to be tax efficient? Though not as much of a potential for higher returns, ETFs are generally more tax efficient when compared to mutual funds.

Who should consider investing in Mutual Funds?

  • **Those that are looking for potentially lower annual expenses. **It’s not always safe to assume that ETFs are going to be the cheapest option when you annualize the expenses. There are plenty of index mutual funds that have lower annual expenses than any exchange-traded fund out there.
  • **Anyone worried about bid-ask spreads. **When buying an ETF, specifically a low-volume ETF, you may need to consider the bid-ask spread. Mutual funds always trade without a bid-ask spread.

What are the downsides to ETFs and Mutual Funds?

Now that you know the upsides, it's important to consider the drawbacks – sometimes the downsides help your decision making more so than the upsides!

  • ETFs have large bid-ask spreads: The price of an ETF may be less than its actual underlying value because of the bid-ask spreads.
  • ETF fee waivers can expire: The fund sponsor can let these fee waivers expire which will cause the gross amount to increase without being reflected in the net amount.
  • Index Mutual Funds will never outpace the market: Because they are tied to the performance of an index, they will only ever be as strong as their weakest link.
  • Mutual Funds may underperform the market: Because the assets are being actively traded, it’s possible that some wrong moves or unforeseen circumstances can cause them to underperform.
  • Mutual Funds are not always tax efficient: The actively-managed funds have more activity. This increased activity causes the taxes to add up quickly.

Which is better: ETFs or Mutual Funds?

Unfortunately there is no simple answer to this question. Every person is in a different financial situation, with different short-term and long-term goals, different incomes, different economic standings, and different portfolio sizes. The best thing you can do is learn the pros and cons of each, and make an educated decision for yourself.

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