Luisa Rollenhagen is a journalist and investor who writes about financial planning for Wealthsimple. She is a past winner of the David James Burrell Prize for journalistic achievement and her work has been published in GQ Magazine and BuzzFeed. Luisa earned her M.A. in Journalism at New York University and is now based in Berlin, Germany.
Most discussions about investing—particularly for beginners—will inevitably cover ETFs and mutual funds. While mutual funds and ETFs are similar, there are some important differences between the two. Which one is “better“ depends on what kind of investor you are and what kind of investing you want to be doing.
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ETFs stand for exchange traded fund, which is a fund you can invest in that functions as a sort of basket: It contains a wide selection of stocks, bonds, or other assets, depending on the ETF. It allows you to invest in wide swaths of the market without having to go into the time and effort (and cost) of selecting individual stocks, which is quite risky. ETFs let you participate in the market without the expense of buying individual shares because ETFs usually invest in fractional shares of companies, which obviously only cost a fraction of what a whole share costs.
ETFs don’t usually require any human management, so they don’t have high management expense ratios (MERs), which means that high operating costs aren’t passed along as fees to investors.
Mutual funds are similar to ETFs, but they differ from their low-cost sibling in terms of fees. Like ETFs, mutual funds function like a basket that contains various stocks, bonds, or other assets, but those assets have been individually selected and managed by a fund manager. That means that a mutual fund is actively managed and therefore will have higher fees.
Differences between ETFs and Mutual Funds
One of the key structural differences between mutual funds and ETFs is their respective trading times. Mutual funds trade once a day at the end of trading day. That’s significant because a stock (or multiple stocks) included within a mutual fund might rise and fall throughout the day, but whatever that price is at the end of the day is the price you’re stuck with—for better or for worse.
An ETF, on the other hand, trades throughout the day. That means that if you’re actively managing your ETFs—or someone is actively managing them for you—you can react to price changes throughout the day. Let’s say you believe an ETF is going to rise throughout the day, so you could buy an ETF early in the market day and profit from its rise. But ETFs work like any other asset and can experience fluctuations in price throughout the day, both positive and negative.
Management expense ratios (MER)
As mentioned before, cost plays a huge role for investors deciding whether to invest in ETFs or mutual funds. ETFs tend to be more cost-effective because of their low MERs. ETFs usually trade for free, and because they’re usually not actively managed—meaning there’s no person actually managing the funds—there’s no trading commission or high management fees.
ETFs are generally considered to be passively invested assets—the slow-cooker method of investing that employs a “set-it-and-forget-it” approach. You establish a set amount to invest in regular intervals into your ETFs and then just… leave it alone. The diversification inherent in your ETFs will heighten your chances of steady growth that mirrors the market’s growth. This laissez-faire approach also means lower fees for you.
The assets that are contained within a mutual fund are actively managed by the fund manager, who gets a chunk of the fund’s annual worth, usually between 1-2%.
Control and flexibility
All that active investing has a significant benefit: If you’re the kind of investor who wants close control over what kinds of securities you’re putting your money into, then a mutual fund will give you more control than an ETF will. Mutual fund managers often build portfolios around a specific goal or strategy which they’ll actively pursue, while ETFs tend to simply mirror the markets they’re based on. Mutual funds also offer more control over what kinds of assets are included in the fund, while ETFs tend to represent a wider variety.
Some mutual funds may give off annual capital gains if they sell investments throughout the year. While that’s obviously nice for you—who doesn’t like gains?—it also means you’ll have to pay capital gains tax for the year in which you received them.
An ETF, on the other hand, is usually unlikely to create capital gains, so they’re often considered to be more tax-efficient.
Similarities between ETFs and mutual funds
The biggest similarity between an ETF and a mutual fund is that they both have built-in diversification. Since they each basically bundle together a wide variety of assets such as stocks, bonds, and other securities, they give investors access to wide swaths of the market—which is beneficial if you don’t have the money, time, energy, or risk tolerance to pick out individual stocks.
Another great benefit to diversification? Less risk. Putting your eggs in many baskets is simply less risky than investing your life savings into one or two stocks
Pros and cons of mutual funds and ETFs
As you can probably tell right now, each fund is useful in its own way, depending on what kind of investor you are and what you’re looking for. Here’s a run-down of their individual pros and cons:
Higher flexibility in selecting securities. Because a mutual fund is actively managed and follows a specific goal or strategy, they tend to allow investors more choices in what kinds of securities are included in the fund.
Prevalance. Mutual funds are more numerous than ETFs.
Active management. Since mutual funds are usually actively managed, you’ll benefit from the expertise of the fund manager and their team of researchers.
Higher fees. High transaction costs, trading commissions, management fees, and capital gains taxes—all of that can really eat into your profits, so make sure you’re not operating on a loss when investing into a mutual fund.
Higher minimum investments. Mutual funds also tend to require higher minimal investments, which could be a deterrent for newbie investors or those on a budget.
Potentially riskier. An actively managed fund can carry more risk with it, since managers are trying to “beat” the market instead of mirror it, which can put you at a higher risk for losses.
Lower fees. Because ETFs are usually passively managed, they tend to have lower management expense ratios and low investment minimums. This makes them very accessible for newbies and the budget-conscious.
Ideal for passive investors. ETFs are the go-to asset for robo-advisors because of their low-cost, low-risk strategy. And the fact that ETFs aren’t trying to beat a market might have its benefits: A 2016 study by S&P Dow Jones Indices found that over the past 15 years, 92.15% of large-cap managers, 95.4% of mid-cap managers, and 93.21% of small-cap managers failed to meet their respective benchmarks. Some suggest that a strategy that mirrors market indexes instead of trying to beat them may achieve more consistent long-term results. Or as Joseph Grieco, a Certified Financial Planner and owner of WealthKeep.org, explained to us: “Stop trying to beat the market, because you won’t. Learn to be the market by adopting a superior passive investing strategy, using low cost, no-load index mutual funds and exchange-traded funds.”
Less flexibility. You can’t really sell individual assets within an ETF.
Not conducive to short-term strategies. Because ETFs usually aim to mirror markets, you’re less likely to see benefits if you only hold assets for short amounts of time, such as five years or less. That also makes you more susceptible to market fluctuations. If you’re looking to access your funds in a shorter amount of time, then something like a high-interest savings account may be more appropriate.
Whatever type of fund you choose, make sure you’re honouring your financial goals and your level of comfort. And if all this talk about diversification and ETFs has you eager to get started investing, now might be a good time to join Wealthsimple. We offer state-of-the-art technology, low fees, and the kind of personalized, friendly service you might have not thought imaginable from an automated investing service. Get started investing in a matter of minutes.