[Disclaimer: Before delving into the differences between mutual funds and exchange traded funds, we must acknowledge that SMMC staff are not licensed financial professionals. All securities are subject to market risk, with investment performance impacting any potential returns. Seek guidance from qualified professionals for accurate and tailored advice in navigating these complex financial products.]
Both Mutual Funds and Exchange Traded Funds (ETFs) are investment products that gather money from many individual sources of other securities, like individual bonds or stocks. This offers investors an easy way to invest across a variety of investments and considered is to be relatively low risk due to diversification. They typically consist of a variety of investments or securities bundled together or tracked across different industries.
The primary objective of these funds is to assist investors in tracking a specific sector or achieving particular investment goals. For example, an investor interested in the semiconductor industry can purchase shares of a mutual fund that focuses on this sector or invest in an ETF that tracks a semiconductor index fund.
What is a Mutual Fund?
Mutual funds are a type of investment, or security, that includes a diversified portfolio of other securities. The majority of mutual funds are actively managed by an investment professional, but some may be passively managed. Mutual funds earn income through capital gains and interest.
Capital gains is when the price of the units of the mutual fund that was purchased by the investor goes up in value. The difference in the purchase price unit and the selling price per unit is known as capital gains or capital losses. On the other hand, interest income can be earned for holding the securities, it is in the form of dividends for equity securities and in the form of interest for debt securities in the mutual fund.
NAV = Value of a Mutual Fund
Investors purchase shares of the mutual fund in the form of units measured with the help of NAV (Net Asset Value). NAV represents the fund’s per share intrinsic value (Chen , 2024), and the value of these shares fluctuates based on the performance of the underlying assets such as stocks or bonds held by the fund. These funds’ intrinsic value per share or fair market value is assessed once a day by valuing the assets within the fund. This calculated price is used in case of a purchase or redemption of units within the fund. As these redemptions or buy orders of the fund are filled on a daily basis, the NAV is calculated by subtracting the Total liabilities from the Total value of the fund.
Mutual funds are open ended funds which means that they can issue or retire units of the funds based on the demand. Since mutual fund shares do not trade on an open market, this issuance and redemption of shares happens directly through the fund itself based on investor demand.
What is an Exchange Traded Fund?
In the case of Exchange Traded Funds (ETFs), the units are traded on the stock market like common shares. The ETF pools money from like-minded investors to invest in a diversified portfolio of financial securities. These funds do not require active management and are therefore passively managed. The price fluctuates throughout the day and is actively bought and sold on the open market throughout the trading day. As a result, ETFs provide investors with flexibility and liquidity to buy and sell units of the ETF during the trading hours since they are passively managed in comparison to actively managed mutual funds.
Key Differenes Between Mutual Funds & Exchange Traded Funds
When considering investment options, understanding the differences between mutual funds and exchange-traded funds (ETFs) is essential. Let's delve into the fundamental differences.
Management
Mutual funds are typically actively managed, trade securities within the fund to achieve specific investment goals. However, there are exceptions where mutual funds are passively managed, mutual funds are designed to replicate the performance of a specific market index like the S&P 500 or the total U.S. stock market. The fund replicates the purchase or sale of securities in the index in the same proportions as the S&P 500 index itself.
On the contrary, ETFs are predominantly passively managed. They are designed to track a particular index or asset class and require minimal to no active management. This passive approach aims to replicate the performance of the underlying target index. Asset classes are the major categories that investments can be grouped into, such as stocks, bonds, cash, real estate, and commodities.
Trading
One significant contrast lies in how these investments are traded. Mutual funds are open-ended funds that are not traded on an exchange. Transactions occur once per day, with orders executed at the net asset value (NAV) at the market close. Investors buy and sell units directly to the fund.
In contrast, ETFs trade like stocks on a stock exchange. They can be bought and sold throughout the trading day at market prices, which fluctuate based on supply and demand. This intraday trading flexibility allows investors to react quickly to market movements.
Costs
The fee structures between mutual funds and ETFs differ considerably. Mutual funds often come with a variety of fees, including operating expenses, sales load fees, and potential redemption fees. However, these fees can sometimes be avoided based on the amount invested or specific terms outlined in the fund's prospectus.
ETFs generally have lower costs compared to actively managed mutual funds. Investors incur broker-dealer fees for purchasing securities, along with service provider fees charged by the ETF provider. These fees tend to be lower due to the passive management approach of most ETFs.
Investment Amounts
Some mutual funds may not be suitable for small investments due to their minimum initial investment requirements. The minimum investment amount can be $500 or more for a mutual fund, making mutual funds less accessible for investors with limited funds. However, not all mutual funds require minimum initial investments and many allow for recurring contributions of as little as $5, $10, or $25 per month (The Investopedia Team, 2022).
ETFs may offer a better option for smaller and less consistent investments as investors can start with amounts as low as $1. Depending on the ETF, the minimum investment value can vary from $1 to $50, allowing investors with smaller amounts of capital to participate in the market.
Automatic Transactions
With mutual funds, investors can set up automatic transactions, enabling them to make investments or withdrawals on a recurring basis. This feature provides convenience and allows investors to systematically contribute to their investment over time.
In contrast, ETFs do not support automatic investments and withdrawals. Investors cannot set up recurring transactions to automatically invest in or withdraw funds from an ETF. As a result, investors need to manually execute each transaction, which may require more active involvement in managing their investments.
Summary
| Feature | Mutual Funds | Exchange Traded Funds |
|---|
Management
| Actively managed fund in most cases with exception of passively managed index mutual funds. | Passively managed and requires little to no management as they are designed to track an index. |
| Trading | Mutual funds are open ended funds that are not traded on an exchange. Orders are executed once per day and units are bought and sold to the fund. | ETFs are traded like stocks in the stock market. They are constantly fluctuating in price and are constantly bought and sold throughout the day. |
| Costs | Mutual funds have a variety of fees that include operating expenses and sales load fees. They might also have a redemption fee. Some of these fees can be avoided based on the amount invested. Ask your financial advisor or refer to the prospectus for more info. | ETFs have a broker-dealer fee for the purchase of the security along with a service provider fee charged by the ETF provider.
The fees in general are often much lower in comparison to an actively managed mutual fund. |
| Investment Amounts | A mutual fund may not be suitable for small, inconsistent investing. The minimum initial investments, when required, are usually a flat dollar amount which can range from $500 - $5,000. | ETFs may be a better option for investments of small amounts that are less consistent as one can invest as low as $1 into an ETF. Depending on the ETF, the minimum investment value can vary from $1 - $50. |
| Automatic Transactions | One can set up automatic transactions with mutual funds (i.e., make investments or withdrawals in a mutual fund on a weekly, monthly, or quarterly basis). | With ETFs, one cannot make automatic investments and withdrawals into or out of an ETF. |
Understanding the nuances in investment amounts and automatic transactions can profoundly impact investors' decisions when choosing between mutual funds and ETFs. Mutual funds may require larger minimum initial investments and offer the convenience of automatic transactions for recurring investments. ETFs may be more accessible for smaller investments but lack automatic transaction capabilities. These differences, along with variations in management style, trading approach, and associated costs, underscore the importance of informed decision-making aligned with investors' financial goals and preferences.
In conclusion, investors should carefully consider these distinctions to select the investment vehicle that best suits their needs and circumstances.I However, navigating investment decisions can be complex. It is often beneficial to consult with a trained financial professional who can provide personalized guidance tailored to your overall financial goals, capacity, and risk tolerance.
Sources
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