Many of us like the thought of investing. Who wouldn’t want to grow their money without too much effort? But it can be a complicated mess of jargon, different opinions, and advice out there.
So, we want to cut through the noise and set some things straight. What is the best type of investment to make — ETF vs. mutual fund?
If you’re looking to start investing and want to familiarize yourself with terms like ETF, mutual fund, and index funds, you’re already off to a great start. The best thing to do when starting to invest is research. This blog is a great place to start.
What’s an ETF?
An ETF is an exchange-traded fund. By exchange-traded, it means that it’s traded on major stock exchanges like the New York Stock Exchange or Nasdaq.
The “fund” part of an ETF means that it’s a collection of several hundred different stocks or bonds merged together into a single fund.
It’s pretty similar to how an index fund works, but there are some differences.
The biggest difference between an ETF and an index fund is that ETFs are listed, bought, and sold on the stock exchange which means the price can change throughout the day when the markets are open. Index funds will only change the value at the end of the day.
What’s a mutual fund?
A mutual fund is essentially a pool of money collected from several investors that is managed by professional money managers. These managers allocate the fund to produce the best capital gains or income for the investors.
For those who would rather not manage their own investments, mutual funds are a great alternative that’s typically low-risk and diversified. However, there are usually higher costs to pay for actively managed mutual funds.
ETF vs. mutual fund: Which is better?
ETFs and mutual funds have plenty of similarities and differences.
Both ETFs and mutual funds work with a portfolio of stocks and/or bonds and track indexes. By nature, this means that they are generally considered lower risk than investing in individual stocks because you can spread the risk across multiple stocks instead.
Where they differ is in the fees mostly. ETFs are generally more cost-effective and liquid. Mutual funds have the benefit of being actively managed by financial advisors and money managers, but that comes with a higher cost to pay.
Why choose an ETF over a mutual fund?
ETFs are a popular way to invest money, but what makes them so special? Here are some of the top benefits of investing in an ETF.
With an ETF, all holdings must be published at the end of each day, whereas with a mutual fund, they only need to be published once a month. This means there’s a greater sense of transparency for anyone looking to invest in that particular fund.
An ETF offers diversification because you can purchase multiple stocks across industries with a simple click of a button. The great thing about this approach is that it lowers your risk. Rather than putting all your eggs in one or two baskets, you spread the risk over a much bigger group of stocks.
3. Instant access
ETFs are traded on the stock exchange which means buying and selling them is like buying a regular stock. The moment you buy them, you own them. This also means you have more control over the price because you can choose to purchase it when the price is lower.
It can really pay to keep an eye on how the price of stocks fluctuate throughout the day and there are plenty of tools out there to keep on top of them, such as online trading accounts or a website like justETF.com.
4. There’s no minimum investment required
Another advantage that ETFs have over mutual or index funds is that there’s usually no minimum investment required. All you need is the money for the stock you want to buy at that moment.
5. Lower fees
Perhaps one of the most important advantages of an ETF is that the fees are usually much lower than that of an actively managed fund. However, if you are investing heavily in ETFs, beware that the fees can stack up if your broker charges a commission every time you buy or sell.
Why choose a mutual fund over an ETF?
Not interested in an EFT? If you want a more hands-off approach to investing, perhaps a mutual fund is better suited to you. Here are some of the benefits of using a mutual fund.
1. A hands-off approach
If you don’t like the thought of managing your investments on a day-to-day basis, a mutual fund could be just the ticket.
Mutual funds are actively managed by people who live and breathe the stock market. They follow the market index of several popular stock indexes to track performance.
The downside to this is that like with any human, there’s room for error. It also means that the fees tend to be higher because you have to cover the cost of money managers and analysts.
For those going down this route, the best thing you can do is plenty of research on selecting the right managers for your money. There are lots of different types of money managers, with different levels of experience, so make sure you’re picking one that aligns with your own investment goals.
If you want a hands-off approach but like the idea of an ETF, there are some actively managed ETFs out there as well.
2. Spread the risk
One of the number one reasons why mutual funds are popular is because they allow you to spread the risk like an ETF or index fund.
This means that you can invest in multiple stocks within the fund without having to pick individual shares. This, paired with the active management of your investment, means it could be one of the safer ways to invest your money.
What about tax efficiency?
So, what about taxes, you ask? How much money are you going to hand over to the IRS with either ETFs or mutual funds?
In general, ETFs are considered the more tax-efficient option when compared to mutual funds. However, both are treated the same in the eyes of the IRS. Both are subject to capital gains tax and any dividends you receive will be taxed as well.
The difference is that ETFs are structured in a way where taxes are minimized for whoever buys and sells the stock. An investor will typically incur less tax than if they had a mutual fund.
An accountant will be able to give you the ins-and-outs of what you need to know about either type of fund and reporting any gains to the IRS.
Another alternative: index mutual funds
If the thought of trading on the stock exchange or paying money managers huge fees doesn’t appeal to you, there’s an alternative — index funds.
Index funds might not be the most glamorous way to invest. But they regularly outperform actively managed funds because fund managers are only human and can make errors.
Why index funds are often your best bet
Index funds are something that Ramit personally invests in. In fact, he’s been pretty open about this being where the majority of his net worth is — not in super-secret hedge funds.
But if you’re not convinced by that alone, here are some great reasons why index funds are an excellent choice.
No loading fees
A loading fee is a fee you pay when you buy or sell a fund. Ideally, you don’t want to pay out in either of these cases. Higher expenses cut into your profits and there’s no evidence that these types of funds perform better — in fact, the opposite is often true.
Index funds don’t typically have loading fees because, despite being actively managed, they’re tracked using software that matches the stocks in the market. That means you don’t have to cover the hefty costs of a fund manager or analyst.
If your attitude to risk is anything but absolutely crazy, you’ll appreciate that index funds are one of the least volatile places to put your money. Of course, nothing is guaranteed, but index funds invest in the entire market making them much less volatile.
What’s the catch?
Okay, that’s not entirely true. But the only real downside with index funds is that it means you’ll make money slower. However, if your money stays put, it’s almost certainly going to grow over time.
It all depends on what you want out of investing. If you want to day trade and jump on any change in the market as soon as it happens, perhaps an index fund isn’t for you. If you want to slowly grow your money and set yourself up for a solid future, index funds are the way to go for most people.
They tick all the boxes. Low fees, less risk, passive management, better performance over the long-term – what’s not to love about them?
Does that mean index funds are the only option you should consider? Of course not, ETFs and mutual funds have plenty of benefits as well. Mutual funds are ideal for those who prefer a more hands-off approach and don’t mind about the fees. ETFs are great for those who want to spread their risk across different stocks and want a fund that regularly updates its price throughout the day. As with anything finance or investment-related, make sure you do plenty of research first!