When quizzed, a higher than expected number of investors struggle to understand the differences between mutual funds and exchange-traded funds (ETFs). Indeed, when put into the context of the myriad choice between stocks, bonds and other financial products, many investors seem to think that the difference between mutual funds and ETFs is too negligibly small to warrant their attention. However, there are some important differences between the two that can have a significant impact on the profit yield and the means by which you make it.
First of all, let us look at the similarities between ETFs and mutual funds. Both funds hold a portfolio of stocks, bonds and commodities. There is no difference when it comes to the regulations dictating what they can own. There are also no limits on how many holdings they can own and how much money they can borrow in proportion with the size of their portfolio.
This is where the similarities between the two types of funds end, however. From here, it makes more sense to look at the ways in which they diverge.
ETFs are traded on an exchange, just like regular stocks and shares. You can buy and sell your stake in an ETF in real-time, and its price is dictated by the asking price of the investor at the other end of the deal. You can buy and sell holdings when you want with no penalty for short-term holdings, making them popular with investors who like to exploit the opportunity offered by market volatility. The price of ETFs tends to track the index prices of commodities in the current market conditions.
Since the transactions involving ETF shares take place between different investors, the fund manager typically has little to do other than making sure that the price of the ETF aligns itself closely with the net value of the sum of the assets that it contains. This is a relatively simple job that can effectively be managed by a computer program.
As opposed to ETFs, where transactions are carried out between investors, when you buy into a mutual fund, your dealings will be with the company that manages it. Prices are not as dynamic as ETFs because they do not change throughout the course of a day. Instead, they are based on the net value of the commodities in the share at market close every day.
Mutual funds are “actively” managed by investment managers. Instead of simply tracking markets, mutual funds try to beat the index through shrewd investment strategy. The money that is paid to the human analysts that help to make these decisions is quite substantial, making mutual funds typically more expensive than ETFs. Another difference between mutual funds and ETFs is that mutual funds tend to charge a penalty fee of 1% if you decide to sell your holding after a period of fewer than 90 days.
Making the choice between investing in a mutual fund or an ETF will depend on your specific needs. ETFs are simpler, offer more liquidity and are generally the cheaper option. However, if you are looking for a fund that looks to win big off small foreign companies in niche markets, mutual funds may be the best choice for you.