Arthur J. Canter, CPA/PFS, CFP®
What’s the Difference Between ETFs and Mutual Funds?
This is a question that arises pretty frequently, as ETFs have become wildly popular, sometimes at the expense of mutual funds.
The Motley Fool has an excellent description of the differences. Here’s their take on it.
What is an ETF?
An ETF, or exchange-traded fund, is an investment vehicle that pools money from investors and uses the funds to buy a basket of stocks, bonds, and other securities. Investors can buy and sell shares of an ETF just like they would buy shares of a stock from a stock exchange such as the Nasdaq or the New York Stock Exchange, hence the name exchange-traded fund.
ETFs commonly track a market index. However, there is a growing number of actively managed ETFs. An active fund manager tries to outperform a benchmark index by being more selective with their stock picks.
What is a Mutual Fund?
A mutual fund is an investment vehicle that pools money from investors to buy a basket of stocks, bonds, and other securities. Investors buy shares of a mutual fund directly from the company issuing shares, such as Vanguard, or through their accounts at discount brokerage firms like Schwab, TD Ameritrade, E*TRADE and Fidelity.
Mutual funds are more often actively managed compared to ETFs, but you can also buy mutual funds that track a market index. Index funds will generally have lower expense ratios than actively managed mutual funds, and the expense ratios are often similar to their ETF counterparts.
Differences Between an ETF and a Mutual Fund
The differences between ETFs and mutual funds can have significant implications for investors.
One big difference to consider is how shares of the funds are priced. Since ETFs are bought and sold on a stock exchange during trading hours, market forces dictate the value of the fund itself. If there's a sizable demand for the fund, it could be priced higher than its net asset value, which is the underlying value of the securities held by the fund.
The opposite is also true. If there's a sudden rush to sell shares of that specific fund, it could be priced below the net asset value. That's usually not an issue for most ETFs with high liquidity (many shares being traded each day).
By comparison, mutual funds are always priced at their net asset value at the close of every trading day. So, what you pay for, or sell for, is equal to the underlying value of the securities.
You can easily reinvest dividends from mutual funds just by checking a box on your application form, but the ability to reinvest dividends from an ETF will depend on whether your broker offers a dividend reinvestment plan for your preferred fund. Most online brokers now have $0 standard commissions for ETFs. If you buy your mutual fund through your broker, such as Schwab or Fidelity, you may be charged a transaction fee.