If you’ve been investing for any period of time, you’ve likely come across two popular investment options: exchange-traded funds (ETFs) and mutual funds. Both give exposure to a diversified basket of investment securities, but each contains distinct characteristics that make them better suited for investors pursuing particular goals.
What Are ETFs?
ETFs are investment funds traded on an exchange, just like stocks. They hold a basket of stocks, bonds, or other assets, and their price fluctuates throughout the day as they are bought and sold. ETFs are passively managed, meaning they track a specific index (ex: S&P 500) or a basket of securities and aim to replicate its performance.
What Are Mutual Funds?
Mutual funds are also investment funds that hold a basket of stocks, bonds, or other assets. However, they are not traded intraday on an exchange, and their price is determined by their net asset value (NAV) at the end of the trading day. Mutual funds can be actively managed, meaning a professional manager makes investment decisions to try to achieve a particular portfolio goal, or passively managed, meaning they track a specific index.
ETFs vs. Mutual Funds: Understanding the Key Differences
As noted above, ETFs are traded on an exchange, just like stocks, and can be bought and sold throughout the trading day. Mutual funds are not traded on an exchange and can only be bought or sold at the end of the trading day at their NAV.
ETFs generally have a lower expense ratio than mutual funds. The expense ratio is the annual fee charged by the fund to cover its costs. Since ETFs are passively managed, they typically have lower expenses than actively managed mutual funds.
Mutual funds often have a minimum investment requirement of as high as $1,000 or more. In contrast, many ETFs do not have a minimum investment requirement, and you can buy as little as one share.
Typically, ETFs exhibit greater tax efficiency compared to mutual funds. This advantage is largely due to their unique structure and trading mechanism, which contribute to a lower capital gains tax liability. One feature of this unique structure involves the creation and redemption of shares through in-kind transactions, thereby avoiding taxable events. This mechanism, combined with the fact that they generally experience less turnover and rebalancing, reduces the likelihood of selling appreciated securities. Additionally, the tax obligations for these funds are only incurred when the investor decides to sell, unlike mutual funds which distribute capital gains to shareholders throughout the investment period.
The Diversification Illusion
Investors often believe investing in an ETF or mutual fund that tracks a broad market index, such as the S&P 500, provides sufficient diversification. While it’s true that these funds hold a basket of different stocks or bonds, a truly diversified portfolio will contain exposure to several different asset classes with different investment characteristics and volatility. Determining that asset allocation mix is more critical to the overall health of the portfolio than any choices one makes regarding fund selection or fund type.
For example, an investor who holds only an S&P 500 index fund may be overexposed to risks in large-cap U.S. stocks and miss out on the diversification benefits of other asset classes like international stocks, small-cap stocks, real estate investment trusts (REITs), or bonds.
Investors should consider their entire portfolio allocation and ensure they are diversified across different asset classes with varying risk and return characteristics, especially those close to retirement age or in retirement who depend on their portfolios to generate retirement income.
Instead of relying solely on ETFs or mutual funds that track a single index, investors should build a well-diversified portfolio that includes exposure to different asset classes based on their individual investment goals and risk tolerance.