Hopefully, at this point in your financial journey you have come to understand the importance of diversification. That is, by mixing the types of investments you make, you can mitigate risk and yield higher long-term returns.
Mutual funds and exchange-traded funds (ETFs) are two types of investment vehicles that are designed to be diversified. By packaging a variety of securities together—including stocks and bonds—mutual funds and ETFs offer investors a way to diversify their money while purchasing a single product.
These two types of investments are similar but have very important differences.
Mutual Funds
Mutual funds are companies with an investment portfolio operated by professional money managers. When investors buy a share of a mutual fund, they are purchasing a proportion of the portfolio’s value. So, mutual funds are owned by many investors who pool their money to invest in a “basket” of stocks, bonds, and other assets. A mutual fund is designed and managed in a way to achieve the investment objectives in its prospectus.
ETFs
The ETF as we know it today has its beginnings in 1993. Like mutual funds, ETFs are collections of securities, including stocks, commodities, bonds, etc. However, while mutual funds have investment objectives that the money managers try to achieve, ETFs only try to track an underlying index.
Also, unlike mutual funds, ETFs are traded on an exchange, so their prices fluctuate throughout the day, similar to stocks. Mutual funds, on the other hand, only trade once a day after the market has closed.
Which is right for you?
Since mutual funds are actively managed, they generally have more costs associated with them. Also, they often have a higher minimum investment requirement than ETFs. However, ETFs are popular because they are passively managed and have much lower fees.
Another advantage of ETFs is that they are more tax efficient since they don’t distribute as much capital gains from frequent trading. However, if you invest on a frequent schedule, you can end up paying a commission each time you buy more ETF shares. In this case, you may be better off with mutual funds.
Since mutual funds are actively managed, they have the ability to “beat” the market. ETFs can only hope to mirror an index fund, so they will never surpass the gains of the market. But that also means they won’t underperform the market, which is often the case with actively managed mutual funds.
For most people, a well-rounded portfolio will include both ETFs and mutual funds. Talk to your financial advisor to find out what will work best for you.
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https://www.investopedia.com/terms/d/diversification.asp
https://www.investopedia.com/terms/m/mutualfund.asp
https://www.investopedia.com/terms/e/etf.asp
https://www.investopedia.com/articles/exchangetradedfunds/08/etf-mutual-fund-difference.asp
