ETF vs. mutual funds: What's the difference, and which is right for you?

ETF vs. mutual funds: What's the difference, and which is right for you?

If you're new to the world of investing, you have probably heard of ETF and Mutual Funds many times. While it may be confusing, both are, in essence, baskets of stocks picked by professionals. Thus, if you're planning to invest your money, these two are likely your options.

The significant difference between these two is their management system. Mutual funds are usually actively managed, buying, or selling assets within the fund. ETFs are mostly passively managed, typically tracking a specific market index.

Learning more about the difference between these two gives you an idea of which option is ideal for you.

Let's take a quick look at the similarities and differences of both.

ETF and Mutual Funds both offer diversification

If there's another similarity between ETF and Mutual funds, that would be diversification.

If you don't have any idea, diversification is a strategy that reduces your investing risk. It works by spreading your investments across many stocks instead of putting it all in a single one.

This way, even if one of the stocks in the mutual fund crashes, you will only lose a part of your investment.

Both the ETF and Mutual Funds offer this perk, but that's where the similarities end.

Differences between ETF and Mutual funds

There are five significant differences between these two that you need to understand. These things will also serve as factors in evaluating which one is suitable for you.

Management System

Mutual funds have professional managers who attempt to beat the market by buying and selling stocks using their Investing expertise. This system is what we call active management.

In simple terms, mutual funds offer convenience on your part since there are experts who will do the work for you.

The downside of these is that experts won't do it for free, and they would slash quite a lot from you.

On the other hand, ETFs operate on passive management. In simple terms, all the buy and sell will be on you. It will, however, save you from a ton of expenses.

In the short term, actively managed funds may outperform ETFs. However, it can be different in the long run.

Going for the ETF will save you from many expenses, especially if you plan to invest on a long term basis.

The Expense Ratios

Some ETF expense ratios cover as low as 0.03%. That's just 0.30 dollars per year if you invest a thousand.

On the other hand, having a professional fund manager costs a lot of fees. Active management usually slashes 1-2% of your actual investment.

That means your fund manager gets 20 dollars per year for an average of a thousand dollars of investment.

Even if the stocks went down and your money gets slashed, your fund manager still gets 2% out of it.

Thus, in the long run, mutual funds aren't exactly a great option.

The Trading System

ETFs usually track an index. However, they come with a twist. ETFs get traded all day like stocks, with their prices based on supply and demand.

Traditional mutual funds, even those based on an index, gets priced and traded at the end of each day.

If you're interested in trading frequently and you're a do-it-yourself type of person, ETF is your choice.

The Taxes

Because of how ETFs get managed, they are usually a lot more efficient when it comes to tax than mutual funds.

If you buy an ETF, you won't pay capital gains taxes unless the shares get sold for a profit.

Mutual funds, since it's actively managed, often get bought and sold frequently. The capital gains taxes get spread on to everyone who shares in the fund. In simple terms, you can owe capital gains taxes even if you never sell your share.

The Required Minimum Investment

When it comes to the amount of investment required, ETFs provide a cheaper option. Mutual funds tend to require at least a thousand dollars or more.

Thus, if your budget for investment isn't that great, an ETF will be your choice.

Final Thoughts

Just by looking at the above information, you'll see why ETF gains popularity to many. Its low cost and small expenses for tax and fees are ideal compared to mutual funds.

The thing is, investors shouldn't assume that any investment is low cost. Thus, you should also consider the fees in the long run, not just the asset per se.

In general, ETFs are an affordable option that gives investors a broad market. At the same time, it can still provide diversification that mutual funds offer.

If you're about to choose, always remember that an ETF will save you from more fees than mutual funds. Thus, if you can take it on yourself to do the buying and selling, then, by all means, you have a better option.

Published: 12/02/2020
ETF vs. mutual funds: What's the difference, and which is right for you?
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