Mutual Funds vs ETFs
What’s the Difference
Exchange-traded funds (ETFs) and mutual funds are two popular types of investment vehicles that allow investors to pool their money and buy a collection of securities that match a specific investment goal. Both ETFs and mutual funds have some advantages and disadvantages, depending on the investor’s preferences and needs. Here are some of the main differences between ETFs and mutual funds:
How They Are Created and Traded
Mutual funds are created by investment companies that gather money from investors and invest it according to the fund’s prospectus, which outlines the fund’s objectives, strategies, risks, and fees. The fund’s portfolio of securities is managed by a professional fund manager who makes buy and sell decisions on behalf of the investors.
ETFs are created by investment companies that form a new company and transfer a block of securities to it, usually to track the performance of a specific index, such as the S&P 500. The investment company then sells shares of the new company to the public. ETFs are traded like stocks on stock exchanges and can be bought and sold through broker-dealers.
How They Are Priced
Mutual funds are priced once a day, at the end of the trading day, based on the net asset value (NAV) of the fund’s securities. The NAV is calculated by dividing the total value of the fund’s assets by the number of shares outstanding. Investors who buy or sell mutual fund shares during the day will receive the same price, regardless of when they place their order.
ETFs are priced continuously throughout the day, based on the supply and demand of the market. The price of an ETF may differ from the NAV of its underlying securities, depending on the investor interest in the ETF. An ETF may trade at a premium (higher than the NAV) or a discount (lower than the NAV) to its underlying assets. Investors who buy or sell ETF shares during the day will receive the market price at the time of their transaction.
How They Are Taxed
Mutual funds and ETFs are both subject to capital gains taxes and dividend taxes, depending on the type and frequency of distributions they make to their shareholders. However, there are some differences in how these taxes are triggered and paid.
Mutual funds may generate capital gains or losses when they trade securities within their portfolio, which are passed on to their shareholders at the end of the year. This means that investors may owe taxes on capital gains even if they did not sell their mutual fund shares during the year.
ETFs generally trade securities less frequently than mutual funds, as they are designed to track an index rather than actively manage a portfolio. This means that they may incur fewer capital gains or losses within their portfolio, and thus distribute fewer capital gains to their shareholders. Investors may only owe taxes on capital gains when they sell their ETF shares, unless the ETF makes a capital gain distribution due to a change in its underlying assets.
How to Choose Between Them
Both ETFs and mutual funds have their pros and cons, and the best choice for an investor may depend on various factors, such as their investment goals, risk tolerance, time horizon, cost sensitivity, and tax situation. In general, ETFs may offer more flexibility, lower costs, and tax efficiency, while mutual funds may offer more diversification, professional management, and convenience. Investors may also benefit from having a mix of both ETFs and mutual funds in their portfolio, to take advantage of their different features and benefits.
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