Exchange-traded funds, or ETFs, are a relatively new feature of the investing world, whereas mutual funds have been around for decades. That said, mutual fund use is facing a slow decline at the same time that the use of ETFs is increasing rapidly around the world and across a large swathe of investors classes.
The growing interest of retail investors in ETFs has led many to question the comparative value of ETFs versus traditional mutual funds. While they do share some similarities, they are also different in many important ways, and are not always direct competitors for the same investor interest.
In this article we will briefly cover the key differences between ETFs and mutual funds so that you can decide which investment vehicle is the right one for your personal investment needs.
Before we look at the key differences between an ETF and a mutual fund, let’s examine the basics.
A mutual fund is a managed investment vehicle that invests in equities using the pooled funds of all investors. The investors then share in the gains and losses of the fund on a pro rata basis. Some mutual funds have shares themselves that are traded openly on the market, while others have more formal and complex investment requirements, such as minimum deposits, lock-in periods and withdrawal delays.
An ETF is a passive index fund that is designed to track some target benchmark. This means that the fund automatically buys and sells assets as it attempts to mimic the performance of its target benchmark.
For example, an S&P 500 ETF would buy and sell shares from the S&P 500 in an attempt to create a value-weighted basket of shares that is representative of the S&P 500 index. ETFs are traded directly on the market like shares, hence the name, and have no other ownership limitations.
Now let’s look at the key differences between ETFs and mutual funds.
Arguably the most important difference between an ETF and a mutual fund is expenses.
Since ETFs are passive funds that automatically buy and sell securities according to its set parameters, they require significantly less management and oversight, which means generally lower fees. While there is some overlap in the fee range, particularly for more complex ETFs on the high end and more simple mutual funds on the low end, ETFs range from around 0.1% to 1.25% annual fees and mutual funds tend to cluster around 1%-3%.
Mutual funds also tend to come with commission fees from the brokers who sell them (those that aren’t traded on the open market), whereas ETFs do not have this incentive structure in place.
Investment Process and Liquidity
Another key difference between mutual funds and ETFs is the investment process and liquidity.
ETFs can be bought and sold directly on the market using almost any standard retail broker. They act almost exactly like shares in the marketplace, and each have their own unique liquidity. The more stable and mainstream the ETF, the higher the liquidity, while more obscure and complex ETFs will have lower levels of liquidity.
While some mutual funds can be traded on the open market, many are not structured in this way. For those mutual funds that are openly traded, liquidity tends to be low, particularly in comparison to ETFs that offer similar exposure to the market. Mutual funds that are not traded on the market will have their own unique terms for entering and exiting the fund, some of which are quite lax and others of which are very onerous.
With the rapid expansion of the market for ETFs, many are now created and managed by companies with comparatively poor financial backgrounds. These companies face a risk of forced liquidation of one or more ETFs, which can lead to poor returns for ETF holders and an extended holding period while the ETF is formally liquidated.
Mutual funds tend not to face this same risk of sudden liquidation, which makes for a more secure and stable investment.
ETF vs Mutual Fund: Which Is Better for You?
While ETFs and mutual funds may share a few important features, they are generally not in direct competition with one another. It is more accurate to say that ETFs have further broadened the field of investment opportunities that mutual funds started many decades ago.
The rise of ETFs may have made the use of mutual funds redundant for certain investors, particularly those who just want broad exposure to some major equity benchmarks, but they still meet the needs of many other investors for whom ETFs are an inappropriate investment vehicle.