What is the difference between ETFs and Mutual Funds?
You know you should be investing to build wealth and beat the cost of inflation. But when it comes to investing vehicles there are so many options to choose from. Some options you may have come across are ETFs and mutual funds. But what are they and what is the difference? Let’s break it down.
What is an ETF and a mutual fund?
An ETF stands for exchange-traded fund and these type of vehicles are traded on exchanges, such as the S&P 500. When you invest in an ETF, you can buy and trade it yourself without a fund manager.
A mutual fund, on the other hand, is typically managed by a brokerage like Vanguard and the price can vary depending on when you purchase it. Both ETFs and mutual funds are types of investment vehicles that can help grow your money. They have some similarities but also some differences you should consider.
The similarities between ETFs and mutual funds
Here is some good news. Both ETFs and mutual funds tend to be less risky than their hard-partying cousins individual stocks and bonds. That’s because both of these investment vehicles are “baskets” of various stocks and bonds, that help diversify and lessen risk.
You also have a lot of options to choose from with ETFs and mutual funds. You can focus on broad categories or focus on specific sectors.
So with both you may be able to mitigate some risk by having a lot of different items in your basket. You know the saying, “Don’t put all your eggs in one basket!”? Think of taking that advice when opting for an ETF or mutual fund.
Of course with any type of investing there is inherent risk, but there are more risky vehicles like stocks and less risky vehicles like ETF and mutual funds. When you invest you want to keep your risk tolerance in mind, which is how much risk you can reasonably stomach on a personal, psychological and financial level.
The main difference between ETFs and mutual funds
So while ETFs and mutual funds are similar in that they are diverse, less risky, and are tracked on indices there are also important differences to consider as well.
Exchange-traded funds tend to have a lower barrier to entry if you want to get started with investing right away. Why? Because, according to Vanguard, you can buy an ETF for the cost of only one share, which could be between $50 and several hundred dollars.
On the other hand, mutual funds tend to have a set limit that you need to invest. For example, Vanguard’s mutual fund minimum is $3,000. When you think of getting started and you don’t have a lot of money, starting with $50 compared to $3,000 is certainly more doable.
ETFs also tend to have more autonomy with the price and are more hands-on. You can buy them yourself with a market order and get the actual pricing as you go. Mutual funds are the same price for everyone, however the price may shift depending on timing.
According to Investopedia.com, “The purchase of a mutual fund is executed at the net asset value of the fund based on its price when the market closes that day or the next if you place your order after the close of the markets.”
When it comes to taxes, Investopedia notes that both ETFs and mutual funds are taxed on losses and gains in their portfolio. However, ETFs have fewer taxable events, so you might not have to worry about anything there unless you end up selling your shares.
Regarding cost, mutual funds are managed by a team so typically are more expensive than ETFs. There can also be fees involved as well.
You also might have heard the terms “actively managed” or “passively managed”. In this case, mutual funds are actively managed as they are managed by a team. ETFs are passively managed as you typically have a buy and hold strategy and don’t do a lot of trading.
So as you can see, there are a number of differences to consider when choosing an investment vehicle.
Which one should you choose?
If you want to get started with investing, you might wonder which one should you choose? Well, it depends on your personal investing style and goals. ETFs can have a lower barrier to entry as we’ve noted above so that could help you get started. Getting started now with investing, even without a ton of cash, can help you build wealth. It also doesn’t have to be an either/or. You can invest in both if you choose. The key is to know your risks going in, understand what you’re buying, and get started!
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For more info on the difference between ETFs and Mutual Funds, watch our video here.