Both ETFs and mutual funds pool investor money to trade in a portfolio of securities based on a trading strategy, so what are the differences?
In the battle between ETF vs mutual fund, which one is the winner, and why? We checked it out for you.
What Is an ETF?
An exchange-traded fund (ETF) is a financial instrument that pools investors’ money to buy or sell securities that track a particular sector, commodity, index, or trading strategy.
In theory, ETFs and mutual funds are very similar because they both pool money to invest with a particular objective in mind. However, there are some differences.
ETFs are sold on stock exchanges, just like securities. They are tradable whenever the markets are open.
On the other hand, mutual funds are issued by their creators, and their net asset value changes only once a day.
Exchange-traded funds are much more tax efficient than mutual funds.
And lastly, ETFs are usually passive in nature and track particular indexes.
While some index mutual funds also exist, most are actively managed.
Do ETFs Pay Dividends?
Yes, ETFs are required to pay any dividends they receive from the stocks they hold to their investors. They can do this in the form of cash or give additional shares in the fund to them.
Portfolio stocks can give out dividends during the year. The ETF collects these dividends and gives them quarterly to the shareholders.
In a way, ETFs simply act as collectors of dividends; they do nothing except for paying it forward.
This helps reduce their tax burden because the dividend income does not count in their books.
Pros of ETFs
ETF investments have several benefits, such as excellent liquidity, low expense ratios, diversification, and low capital gains taxes.
Let us look at some of these benefits in more detail below.
Liquidity
One key benefit of ETFs is that they are traded just like stocks. Investors can purchase them on margin, short sell them, buy options, or take any positions possible with normal securities.
Their prices are updated every second, with millions of buyers and sellers.
This differs from mutual funds, whose net asset values change only once daily.
Diversification
Most ETFs track stock or bond indexes, which are an amalgamation of various stocks in a particular sector or even an entire economy (like the S&P 500).
They let traders buy a diversified portfolio directly without making one on their own.
For investors to make this portfolio, they would have to spend a lot of time and money buying the relevant stocks.
ETFs provide this beneficial service at a very minimal cost.
Lower Expense Ratio
Most of these funds are passively managed, so their expense ratios are quite minimal.
They don’t need a permanent team to manage the fund and make everyday decisions about which stocks to buy or sell.
On the other hand, actively managed mutual funds typically have management fees, service fees, load fees, etc., because they need a regular team to manage and promote the product.
Lower Capital Gains Tax
ETFs are very tax efficient. Firstly, they are usually passive, so they don’t have to change their composition very often. Hence there is very little chance of capital gains.
Instead of buying or selling stocks directly, they make “creation units,” which they offer brokers. They then trade these creation units in kind rather than cash.
Since the transaction does not happen in cash, there is no capital gain.
Overall, they very rarely create any taxable events, so there are very few capital gains. Hence this additional tax burden on the investor is avoided.
On the other hand, mutual funds buy and sell stocks almost daily, creating taxable events that increase the chance of capital gains tax for those who buy them.
Disadvantages of ETFs
ETFs also have some disadvantages, such as low returns, low dividend yields, and higher costs than investing in a single security. Let’s look at some of them.
Lower Returns
Passively managed ETFs track indexes, which might be over-diversified with several stocks in them.
Instead of tracking an entire index, it is possible to create a high-return portfolio by choosing just a few good stocks.
Higher Costs
While the costs are lower than mutual funds, ETFs still have higher costs than buying a single or just a few securities because their buyers have to bear a management fee.
Lower Dividend Yields
If an investor is interested in dividend incomes, then selecting a good set of dividend stocks will usually outperform the dividend yield of a diversified ETF.
Leveraged ETFs Can Give Poor Returns In The Long Term
Leveraged ETFs use derivatives of stocks belonging to the index rather than the securities themselves. This helps to multiply the returns generated by trading an index.
However, while they amplify the gains, they also do the same things for losses.
It is harder to return from a loss in a leveraged ETF than in a regular ETF because the percentage losses get amplified.
Over time, the ETF returns start to track much below the returns of the actual index. Hence this strategy is only good for very short-term trades like intraday.
Leveraged ETFs are actually a poor choice for a long-term investor, but investors may get confused by the name and the possibility of higher returns.
What Is a Mutual Fund?
Just like ETFs, mutual funds also pool investor money to buy a set of stocks, currencies, bonds, commodities, or other tradable assets based on a particular investing strategy.
However, they are usually actively managed funds and attempt to perform better than purely passive investing instruments like ETFs.
The key benefit of mutual funds is that they allow investors to own a portfolio that qualified experts professionally manage.
These experts, known as fund managers, are obligated by law to work toward the best interests of the investors.
Mutual funds manage huge amounts of assets and invest in several securities at once, which is difficult for a single investor to do on their own.
They are judged on their total market capitalization, as derived from the sum of the market value of all their investments.
Do Mutual Funds Pay Dividends?
Yes, just like ETFs, mutual funds also pass on any dividends they earn from the shares they hold directly to their investors.
They do this so that the investor does not get taxed twice for the dividend income, once at the mutual fund and then again when it is distributed.
Both ETFs and mutual funds simply pass on the dividends that accrue at specific times during the year, as per the fund’s prospectus.
Pros of Mutual Funds
There are many benefits of mutual funds, such as expert management of funds, diversification, convenience, and the chance to reinvest dividends.
Portfolio Management
Managing a portfolio by trading daily is a hard task for most traders.
Mutual funds take away the pain of managing a diversified portfolio and give it to a professional fund manager who usually has years of experience doing this.
They take a small fee for this service, but the problems they remove are worth far more for common investors.
Reinvesting Dividends
Dividends given out by mutual funds can be redeemed in kind by purchasing additional units of the fund, unlike stocks. Reinvesting dividends helps grow the money even more.
Diversification
Just like ETFs, mutual funds diversify their portfolios across several securities. This diversification lowers the risk of major losses for investors.
Most mutual funds might own anywhere between 50 to 200 or even 1,000 stock positions at any given time.
Convenience
Creating a portfolio of securities based on certain investment objectives can be very difficult, but mutual funds let investors get this benefit for just a small cost.
Disadvantages of Mutual Funds
While they might offer a lot of conveniences, mutual funds can also have some disadvantages, such as high expense ratios, possible poor fund management, capital gains taxes, and no possibility of intraday trading.
High Charges
Compared to ETFs and other investment options, mutual funds usually have much higher expense ratios.
There are several types of mutual fund fees, such as management expenses, sales loads, advertising fees, etc. All of these reduce the investor’s net profit and can add up over the long term.
Poor Fund Management
It is possible for fund managers to show funds in a much better light than they really are by abusing their authority. This may include window dressing, churning, and turnover in funds.
Capital Gains Tax
Mutual funds trade in securities daily to keep balancing their portfolio in line with their investment strategy.
Unfortunately, this can create capital gains, and investors have to bear the brunt of the tax on these gains.
No Possibility of Intraday Trading
Some traders might be interested in the possibilities of intraday trading and using derivatives and futures to enhance returns.
All this is not possible with mutual funds. There is only one net asset value (NAV) throughout the day; you can only buy and sell the fund at that price.
ETF vs Mutual Funds: Which One to Pick?
Both ETFs and mutual funds have their own pros and cons. Neither can be said to be absolutely better than the other.
While exchange-traded funds offer low costs, better tax efficiency, and high liquidity, mutual funds offer the chance of higher returns.
Overall, mutual funds are better for advanced investors who don’t mind spending extra money for the chance at better-than-market returns, but ETFs are good for beginners.
Which Is Riskier ETF or Mutual Fund?
Both mutual funds and ETFs have almost similar risk tolerance if the portfolios they hold are similar. Simply being a mutual fund or an ETF does not impact risk tolerance.
However, both are not as risky as buying individual stocks because they offer the benefit of diversification.
A mutual fund or ETF that holds a portfolio of stocks is inherently riskier than one with bonds as its underlying assets.
Mutual funds are usually managed actively, so they have an equal chance of both outperforming and underperforming the market.
Why Are ETFs Cheaper Than Mutual Funds?
Most ETFs are index funds and therefore do not need a team of fund managers to make active decisions on buying or selling securities.
Stocks are bought and sold only when needed to track the index, which can be done without a dedicated team.
This difference in their structure is why ETFs are usually cheaper than mutual funds.
Why Choose an ETF Over a Mutual Fund?
ETFs have some key advantages over mutual funds, such as higher liquidity, lower expenses, and better tax efficiency.
These funds are traded on major stock exchanges, so they are tradable throughout the day. Investors can buy or sell futures on them, make intraday trades, and much more.
There are very few actively managed ETFs, so their expense ratios are much lower since they don’t have a team of fund managers working for them.
Lastly, ETFs rarely pass on capital gains to their investors and have much fewer taxable events due to how they structure their transactions with brokers.
This means investors are not forced to pay unnecessary corporate gains tax and are not burdened with income that might change their tax slabs.
Why Choose a Mutual Fund Over an ETF?
Passively managed ETFs cannot ever hope to perform better than the index they track, but actively managed mutual funds can do this through smart investing.
Mutual funds have a fund manager and a team of professionals to identify opportunities for trades in the market based on the latest market news.
They can make trades that can bring in greater profits to investors than simply tracking a given index.
Additionally, mutual fund prices do not fluctuate the entire day, so they are not subject to regular fluctuations.
Which One Is Better for Beginners?
In most cases, ETFs are better for beginner investors. They are low on fees, instantly tradable, and do not incur a capital gains tax burden on the investor.
On the other hand, mutual funds are more suited for advanced investors who want to outperform indexes through smart investing and are willing to pay the extra price for it.
Even though ETFs may not be able to outperform benchmarks, they offer excellent diversification at a very low price.
Final Thoughts
Both ETFs and mutual funds are excellent ways to invest money in securities, bonds, commodities, or any other asset class rather than cherry-picking securities to build a portfolio.
They let investors diversify their wealth and lower risks.
ETFs are great for beginner investors who want lower costs, but an actively managed mutual fund can give advanced investors higher than market returns. They are also beneficial from a taxation standpoint because they pass on fewer capital gains to investors.
Neither is riskier than the other – it depends on the assets held under the fund.
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