It’s safe to say that exchange-traded funds (ETFs) have solidified its place in the investment community but new investors continue to scratch their heads when there are ETF-versions of popular mutual funds available.
For the purpose of establishing a comfortable nest egg, both mutual funds and ETFs will serve nicely to achieve this goal but understanding their characteristics will make it simpler to pick between the two.
Here are the notable differences between mutual funds and ETFs:
With traditional mutual funds, you can trade shares only at the net asset value (NAV), which is determined at the end of trading day. You can enter the fund’s ticker symbol in your favorite finance website and it’ll just show you the closing price of the last complete trading day.
On the other hand, ETFs can be traded – like stocks – at any time during the trading day. Additionally, they can be shorted, which is done by pessimists who expect certain market indexes to fall.
Mutual funds favor the long-term mindset since investors are not generally focused on the minute-by-minute moves of their portfolio. Meanwhile, ETFs can be used by market-timers and day-traders to capitalize on the volatility of the stock market – but it doesn’t mean long-term investors can’t put ETFs in their basket.
Like mutual funds, ETFs come with annual expenses to pay fund managers and administrative costs. However, the expense ratios for mutual funds are generally higher than their ETF counterparts.
More importantly though, there’s trading costs.
Commission fees for mutual funds tend to be higher than that of ETFs unless the funds are held in an account with the fund company (you won’t pay . Investors who have to pay commission fees for mutual funds may save some money by investing in the ETF version.
Also, mutual funds have minimum investment amounts (partial shares may be traded). For example, many funds require that your first investment must be at least $1,000 and additional investments must be at least $100. ETFs are not subject to such limits – you can trade as little as one share (whole shares only).
You’d have to calculate for the costs of your trading frequency and combine that with the funds’ expense ratios to evaluate the ultimate costs of picking a mutual fund or its ETF sibling.
When mutual funds pay out dividends, investors can take advantage of the automatic dividend reinvestment option – an easy way to stockpile a particular investment while curtailing minimum additional investment requirements.
ETFs do not offer this option so dividends simply end up as cash added to your brokerage account. Reinvesting that money is the same as putting in a buy order, resulting in commission fees.
Opting for automatic dividend reinvestment is regarded as a crucial step for investors to grow their portfolios. However, some investors prefer to receive dividends in cash so they can use that money to re-balance their asset allocation.
If this automated process to accumulating shares is highly appealing to you, mutual funds would be a better fit.