Understanding the difference between exchange-traded funds (ETFs) and mutual funds can be confusing, because in many ways they’re very similar. However, if you are able to keep the few but significant differences in the front of your mind, you’ll likely get a better grasp of the features and benefits of each.
Both are SEC-registered investment companies that offer investors a convenient way to build a diversified portfolio, and can contain hundreds or even thousands of underlying securities. Most mutual funds and ETFs have the same endgame in mind (building your wealth), yet they operate in slightly different ways.
From 20,000 thousand feet, they seem to appear identical. Mutual funds and ETFs are both professionally managed portfolios and offer investors shares of the overall portfolio.
For decades, these types of funds have provided both retail and institutional investors an efficient way to invest in stocks, bonds, and other asset classes. The first mutual fund was launched in the 1970’s by the late Jack Bogle of Vanguard. The now +$275 billion fund with the ticker SPY was the first ETF launched back in 1993. Global regulated funds now total almost $47 trillion.
The entire list of the underlying mutual fund or ETF holdings is known as a portfolio. Most portfolios are composed of a variety of stocks, bonds, or both, but many other types exist. Mutual fund and ETF investors buy shares in the fund, which makes them a proportional owner and entitled to the gains or losses that might result. Any fees or expenses for the fund is shared among the investors.
An important point is that neither ETFs nor mutual funds are FDIC insured and you can lose money investing in both. Past performance of these funds is not a reliable indicator of future performance.
Basic Differences Between ETFs and Mutual Funds
While there are some small, technical differences between ETFs and mutual funds, the most tangible one for investors is how they’re purchased and sold. Mutual funds transact once per day, with all investors selling or buying shares at the same closing price. ETFs trade throughout the day on public exchanges, with many shares exchanging hands at various prices as buyers and sellers react to changes in the market.
Mutual funds are required to report the total value of their portfolio once per day after the stock markets close. The fund then figures out how many shares they have and what each share is worth based on the total value. This is what is referred to in the industry as the Net Asset Value, or NAV. When investors buy or sell a share of the mutual fund, they are forced to transact at that NAV at the end of the day.
All investors queue up their orders throughout the day and the fund settles everyone up by the next morning based on the day’s NAV. To purchase shares, investors either interact directly with the mutual fund company or operate through a broker who has an agreement with the mutual fund company to distribute shares.
ETFs, on the other hand, trade just like stocks. Buyers and sellers place orders on exchanges like the NYSE or NASDAQ during normal market hours (9:30 – 4:00 ET). The price of the ETF fluctuates throughout the day based on market conditions and the value of the ETF’s underlying holdings.
The ability for investors to ‘time’ their trades just like stocks is one of the perceived advantages of ETFs over mutual funds. Most ETF transactions take place close to the ETF’s NAV, but there is no guarantee like there is for a mutual fund transaction. ETFs are available to buy and sell at most places where you can trade stocks, including SoFi Invest®.
Understanding the Difference Between Index and Indices
While we’re on the subject of confusing terms, here’s another one—if you have more than one index, that’s called “indices.” However, if you use the term “indexes” to describe more than one, that’s acceptable, too. Neither word is wrong, so don’t let anyone intimidate you.
An index fund is a type of mutual fund created to match or shadow the action of a market index, like the Standard & Poor’s 500 Index (S&P 500). The S&P 500 is one of the most prominent indexes in the industry. It lists the 500 largest publicly traded companies in the United States. Other prominent indexes include the Dow Jones Industrial Average and the Russell 2000 Index. Index funds are usually associated with a passive investing strategy.
Similarities between ETFs and Mutual Funds
Let’s look at the similarities between ETFs and mutual funds. Both investments allow you to pool your funds with other investors’ funds to ultimately buy and sell baskets of securities in the market. The aim is to diversify and reduce risk compared to investing in a single company. If you were to put all of your money into one company instead, your risk rises and your investment isn’t diversified because your fortunes are tied to that single company.
Both ETFs and mutual funds could also be considered “passive investments,” in that investors are not necessarily making active trades with mutual funds or ETFs. A passive strategy is usually related to a“buy and hold ” strategy, which means you buy the security so that you can hold onto it for a long term. There is not as much action and drama with passive investing as there may be with active investing, which is likely a positive thing for most investors.
That’s pretty much where the similarities end. After that, mutual funds and ETFs feature some important differences.
Mutual Funds Are Available in Two Types
Open-Ended Mutual Funds
Buys and sales of fund shares typically happen directly between you and the fund company. As more investors buy into the fund, more shares are added, which means that the number of eventual fund shares can be nearly unlimited.
However, the fund must undergo a daily valuation by law, which is called marking to market (see a deeper dive on this below). The result of this process is a new per-share price, which has been adjusted to sync with any changes in the value of the fund’s holdings. Your share value is not affected by the quantity of outstanding shares.
• More on marking to market: When you hear this term, it usually refers to the status of the fund’s gains and losses on a daily basis. These gains and losses happen as a result of changes in the fund’s market value. When something is ‘marked to market’, that just means that the current value of the fund reflects the value of the underlying holdings at that given time.
Closed-Ended Mutual Funds
Unlike open-ended funds, closed-ended funds are finite and limited. Only a specific number of shares are issued and no further shares are expected to be added.
The prices of close-ended funds are influenced by the net asset value (NAV ) of the fund, but are ultimately determined by the demand investors have for the fund. Since the amount of shares is fixed, the shares often trade above or below the NAV. If the fund is trading above the NAV (what it’s really worth), it’s said to be trading at a premium; if trading below the NAV, it’s said to be trading at a discount. These premiums and discounts can persist over time and often fluctuate, which poses an additional challenge for investors trying to make sense of whether the fund might be a good investment.
• More on net asset value: this represents the total value of a fund after its liabilities are subtracted (here’s the math: the total value minus the total value of its liabilities, divided by the number of shares). This formula is used for both mutual funds and ETFs. The resulting answer is the per-share price of a fund on a specific day and time, and that’s the price that most closely represents the true value of what the fund is worth.
Most people use the term ETF for any fund that trades on an exchange, but technically, this is not 100% the right term to use. ETFs are just one class of funds within the broader exchange-traded product (ETP) universe. Other ETPs include exchange-traded notes (ETNs) and closed end funds (CEFs).
So, while the word ETF may be thrown around a lot, it’s important to understand the actual fund structure of your investment since there are important differences between the different types. For instance, ETNs are usually debt instruments issued by banks that seek to track an index and they have different risks than ETFs.
Which are More Flexible: Mutual Funds or ETFs?
Generally, ETFs could be considered more flexible—here’s why:
• Flexibility: remember when we talked about net asset value (above)? Mutual funds exist by this formula—the value of the fund minus any liabilities, and divided by the number of shares. Mutual funds can only be sold after the market closes, at the end of the trading day. That’s not very flexible. ETFs, on the other hand, are valued by what investors think their value is, and are traded anytime throughout the trading day. This gives you more wiggle room to trade based on the day’s events.
• Transparency: ETFs have to report their holdings on a daily basis. Mutual funds do not. They report their holdings every quarter or semi-annually.
• Lower tax liability: You’ll have to pay taxes on any capital gains and dividend income, but ETFs have a lower tax requirement than mutual funds. Due to the unique structure of ETFs, they’re often able to reduce the amount of capital gains they distribute each year relative to a comparable mutual fund.
• Lower fees: mutual funds tend to charge different types of fees to cover their business costs. ETFs generally charge lower fees.
• Lower initial investment: as a general rule, mutual funds require a higher initial investment ($1k or $10k). ETFs, on the other hand, allow investors to invest in as little as a single share.
Benefits of Mutual Funds
You could look for a “no-load” mutual fund, which means the shares are bought and sold without charging commissions. This plan may be best for investors who plan to do a lot of trading. If investors have to pay a commission charge every time they buy or sell a security, frequent trading will reduce returns.
Overseen by Fund Managers
Most mutual funds are actively navigated by experienced money managers who steer the fund and invest in companies they believe will lead to outperformance. However, you’d better make sure that your fund manager is outstanding in his field, or you may suffer underperformance relative to a comparable market index.This is harder than it sounds, which is why many investors prefer to choose passive investments that seek to match the performance of the market.
The Benefits of Passive Investing
Passive investing usually incurs lower fees than active investing, and they shadow the strategy path of a particular index, like the S&P 500. In that instance, whatever the S&P 500 does in buying and selling, your passive investment ETF would follow.
You may also pay fewer taxes with ETFs, because you are not buying or selling as much with them. There are fewer transactions to tax and ETFs are generally tax efficient given their unique creation and redemption mechanism that they employ.
Passive investing may instill you with a sense of discipline, as you are going to follow the action of a particular index fund and invest regularly for the long term. No constant, knee-jerk or panic decisions.
The grass (active investing) may not be as greener on the other side anyway. Research by finance professor Ken French reveals that institutions are no better at beating the market than individual investors.
He goes on to say that when investing with a money manager, “You should expect to lose. It’s really hard to identify the great managers. You are wasting your time and money trying to beat the market.”
Working With SoFi Invest
Knowing the difference between ETFs and Mutual Funds is a lot to absorb and keep straight, but you don’t have to go it alone. Working with SoFi financial planners can help you get a better grasp on the differences as it directly relates to your personal situation and future plans. SoFi’s financial planners can work with you to define your investment goals and help pave the way to achieving those goals.
With SoFi Invest, you can choose between active investing or automated investing. However you decide to invest, we’ll work with you to reduce the risk of your portfolio by investing in thousands of assets.
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