Mutual Funds vs. ETFs: What’s the difference?

Mutual funds and ETFs have become two of the most useful tools for investors to diversify their investments.

Mutual Funds Vs ETF

Instead of directly buying a few stocks, bonds, or other types of assets, an investor can easily invest in hundreds or thousands by purchasing a mutual fund or an ETF.

The main difference is that ETFs trade intraday and can be bought or sold at any time, just like stocks, whereas mutual funds can only be bought (or sold) at the closing price of the day (net asset value or NAV)

What are Mutual Funds?

“Mutual funds are collective investment vehicles that pool the capital of several investors to invest in a more diversified and efficient manner in financial assets such as stocks, bonds, and others”

Capital is managed by professionals who decide where and when to invest the money based on the mutual fund’s goals.

Investors benefit from diversification, professional management, and easy access to markets and assets that might otherwise be out of their reach or very complicated to contract.

Investors who decide to invest in a mutual fund should consider its costs and expenses, investment strategy, and historical performance compared to similar funds.

Main characteristics of mutual funds:

  • They can invest in a variety of financial assets in a diversified manner.
  • Shares can only be bought or sold directly or indirectly through the fund provider.
  • Buy or sell orders are only executed after the close of the day.
  • They usually require a minimum amount to be able to invest in them.
  • Usually actively managed but there are also passive management funds.

Types of Mutual Funds

There are many types of mutual funds depending on the class of assets they invest in (equities, fixed income, commodities, etc.), the management style (growth, value, dividends, etc.), the internal functioning (closed-ended, open-ended) etc.

But for practical purposes, we are going to divide all mutual funds into 2 main categories:

Actively managed funds:

An actively managed fund is the most common, in which all investment decisions are made by a professional or team of professional managers.

The Actively managed funds aim to outperform the index they intend to track as the goal. For example, if the fund uses the S&P500 index as a performance indicator, it aims to do better in return than the index itself.

Indexed or passively managed funds:

An indexed fund invests in all the components of a particular market or “index” and is designed to replicate the performance and achieve the same return as the market or market sector in which it invests.

For example, if we want to replicate the return of an investment basket that contains the 500 largest companies in the U.S., we would invest in an index fund linked to the S&P 500 (the index), which precisely buys each and every one of the 500 most representative companies in the U.S. proportionally to their weight within the index.

To do this, which is quite simple, having a team of expert analysts is unnecessary since a simple algorithm can do it.

Therefore, they are completely automated funds with much lower fees than other funds as they do not have a management team deciding where and when to invest.

That is why they are also called passive management funds, meaning no one actively manages the investments.

They simply buy all the components of the market instead of choosing only some of them.

What are ETFs?

ETFs (Exchange-Traded Funds) combine characteristics of both traditional mutual funds and stocks.

They are mutual funds whose shares or participations trade on the stock exchange, just like stocks, and can, therefore, be bought or sold during market hours at the price at which they are traded at that moment.

An important fact is that most ETFs are passively managed, meaning they aim to replicate the performance of an index.

If you are looking for a much more comprehensive article on ETFs, here is our article where we explain them in detail: 👉What is an ETF, and how does it work?👈

Main characteristics of ETFs

  • They can invest in a variety of financial assets in a diversified manner.
  • The shares can be bought or sold between investors.
  • Purchase and sale orders can be done easily during market hours.
  • Normally, the minimum investment is the price of 1 share.
  • They are usually passively managed (although not necessarily).

Which one is better: ETFs or mutual funds?

Although both ETFs and mutual funds allow us to invest in many financial assets in a very simple way, it is important to understand how they differ and what the advantages and disadvantages of each are to decide which might interest us more.

Advantages and disadvantages of Mutual Funds vs ETFs

Pros of Mutual Funds

Active management:

  • Managed by a team of professionals. Although many managers do not manage to beat the market in the long term, some elite investors have proven to be able to beat the market consistently.
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No trading commissions:

  • Most funds today do not charge commissions when making contributions or redemptions. This is better than in the case of ETFs, where whenever you make a purchase (or a sale), you will have to pay the corresponding broker commissions.

Long-term vision:

  • In general, mutual funds are designed to be held in the portfolio for a time, which can favour better investor behaviour compared to ETFs specifically designed for trading.

Cons of Mutual Funds

Active management:

  • Commonly, the management team’s management does not add value. Empirical evidence shows that most actively managed funds do not outperform their benchmark indices in the long term.

Higher costs:

  • Actively managed funds have a team of managers and analysts necessary to make investment decisions, and this has a cost.

Less accessible:

  • Not all mutual funds are available on all platforms.

High minimums:

  • Although not always, there are mutual funds that have high investment minimums, making them inaccessible to many individual investors.

Less flexibility:

  • Traditional mutual funds can only be bought at the end of the day (sometimes with more days of delay), so they are not as agile as ETFs.

Less variety:

  • ETFs offer access to a wide range of sectors, asset classes, and investment strategies, including specific niches and innovative trends, which may not be available through traditional mutual funds.

Less transparency:

  • ETFs usually publish their portfolio composition daily. In contrast, traditional mutual funds usually update their portfolio composition less frequently, typically quarterly.

Active investing vs. passive investing?

In my opinion, the decision between passive investing and active investing is much more relevant than the choice between ETFs or mutual funds.

Remember that most ETFs are passively managed, while most mutual funds are actively managed.

It is important to know what they are and consider the advantages and disadvantages of each investment style.

Advantages of Indexed Funds

Classic globally diversified index funds are both the simplest and most profitable way to invest your money, as demonstrated by simple arithmetic and the historical returns of the last 40 years (since Vanguard launched the first index fund in history in 1975).

It is the great paradox of fund investing:

If you focus on achieving an average return, you are more likely to do better than the rest of the investors.

The main advantages of index funds are:

  • Maximum diversification and less risk.
    • Therefore, these funds avoid the risks of an individual stock’s problems, sector risk, and manager selection risk.
  • Low fees.
    • Since they do not have a management team, they are much cheaper than actively managed funds, and the cost of portfolio turnover is much lower.
  • Simplicity.
    • You don’t need to follow complex strategies with passive management; you need to “buy and hold.” You don’t need to constantly monitor your investments or spend time making them work well.
  • Better investor performance.
    • Evidence shows that most funds perform worse than the market (mainly due to excess costs), but the average investor does even worse. This is mainly due to “market timing” and “fund selection”.

The results will be much better if we remove the temptation to guess the best momentum to buy or sell from the equation and always look for the best funds to invest in. Unlike the trendy funds of the moment, which will stop being trendy so as soon as they have a period of worse results, a simple index fund can be maintained forever, both in good times and bad, and we will never doubt the management team because it doesn’t have one.

So what is better, ETF or index fund?

If you prefer passive investing and are unsure whether to invest in an ETF or an index fund, here are some considerations that may help you decide:

Keep in mind that this is my opinion and is aimed at long-term investors (if you are a trader, an ETF is obviously much better), so it doesn’t hurt to do your own research and consult with your financial advisor if you see it necessary.

Although the costs are negligible in both cases, an ETF’s management fees are sometimes even slightly lower than those of index funds.

ETFs are more accessible than traditional index funds since practically any broker offers them, and they do not have high minimums to invest in them.

On the other hand, an index fund, for example, is much more complicated to contract through traditional channels and also usually has very high minimums that make it out of reach for most investors. Remember that some of these mutual funds may require a minimum investment of several million euros.

However, ETFs are unsuitable for those who periodically contribute small amounts to their investments since they function like any stock and have brokerage fees that make them less suitable for this type of investor.

According to John C. Bogle (founder of Vanguard and creator of the first index fund to come to market), the main problem with ETFs is that they are instruments designed for trading, market timing, and fund selection. As a result, the typical ETF investor achieves returns that are little or nothing like the average market return.

If the original principles of index investing are global diversification, long-term investing, and holding the investment, ETF marketers seek exactly the opposite: daily operations, narrow diversification in certain sectors or countries or commodities, and encouraging investors to enter and exit the sectors that are hottest or most fashionable at a given time.

That is to say, ETFs are tools that can be dangerous for investors’ pockets because they incentivize exactly the opposite of traditional passive management.

In summary, an ETF can be a fantastic tool for certain investors, especially if you can’t find an equivalent index mutual fund. However, it is only if it is globally diversified and for buying and holding in the long term.

Can ETFs and Mutual Funds pay dividends?

Although most mutual funds and ETFs are based on accumulation, some types (distribution ETFs or funds) pay dividends regularly to their participants.

Is an ETF riskier than an investment fund?

The structure of an ETF does not make it riskier than a similar category investment fund.

Other more important considerations, such as the leverage, the market, the types of assets in which it invests, the investment strategy, liquidity, counterparty risk, etc., will determine the risk in ETFs and mutual funds.

As for investor behaviour, the ETF, given its agility and flexibility, can indeed encourage frequent changes that do not contribute anything except generating more commissions for the broker. This aspect could lead certain types of investors to be “more nervous” to make mistakes more often. It is often more important to stay still and do nothing than make hasty decisions.

How to choose between a mutual fund and an ETF

As we have already said, deciding whether you want passive or active investing is the first and most important thing.

From there, the best choice will probably be the investment fund or ETF with the lowest total expenses for you. That said, here are some reasons why:

A mutual fund might be more suitable for you if:

  • You want to invest in active investing and let a professional make the investment decisions for you
  • You have a lot of trust in the fund manager, and they have proven to be able to outperform the market at key moments or over long periods of time.
  • You are a long-term investor who makes small and frequent periodic contributions.
  • Your investment strategy involves rebalancing between different funds.

If you are thinking about choosing a mutual fund, know all the key aspects you should consider:

An ETF might be more suitable for you if:

  • If you are looking for a low-cost indexed mutual fund and can’t find one, it has very high minimums, or the active management alternatives are too expensive.
  • You want to invest in a specific asset, sector, or strategy unavailable in any mutual fund.
  • You enjoy the responsibility of choosing and managing your own investment portfolio.
  • You need flexibility and the ability to make quick investment decisions based on what happens in the market.
  • You like trading or frequently investments changes
  • You have very little money to invest

If you are thinking about choosing an ETF, know all the key aspects you should consider:

👉How to choose an ETF?👈

Related Content

👉 What is an ETF, and how do they work?

👉 Taxes on ETFs in the UK

👉How to choose an ETF

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