A Frugal Rules reader recently asked a question about mutual funds and exchange traded funds (ETFs), the differences between the two and which would be a better fit for her investment purposes. I love to talk about investing in the stock market and felt there may be more readers out there wanting to increase their knowledge about mutual funds and ETFs. Many individuals (myself included at earlier stages in life) lack knowledge about investment choices and therefore make decisions that are either not planned out or not in line with their needs. When properly understood, mutual funds and ETFs can be valuable tools in an investment portfolio. This post is intended to give a high-level overview of mutual funds and ETFs and is not meant to be exhaustive.
Should I Invest in Mutual Funds or ETFs?
To make it very simple, a mutual fund or an exchange traded fund (ETF) are what we refer to as a basket of securities. Think of it as being able to buy one thing that has many parts as opposed to buying 20 individual stocks. There are thousands of investment options available if you’re looking to invest in the stock market and either of these two vehicles can possibly make it much easier for you as you can have a one-stop shop. This can possibly take some of the fuss out of investing in the stock market as you can invest in a handful of mutual funds or ETFs as opposed to a myriad of stocks and bonds. If you have a 401k, then you’re likely already exposed to either mutual funds or ETFs depending on your plan. What I like about both mutual funds and ETFs is their ability to simplify investing; either is a great way to begin investing in the stock market as it makes investing feel less overwhelming.
Are They Completely Opposite?
We’ve already established that mutual funds and ETFs are baskets of securities. For our purposes, right now, that is where the majority of the similarities end. When deciding between a mutual fund and an exchange traded fund there are three, general, major differences. Those three differences are:
- How they trade
- Minimum investments
Because many ETFs track an index like the S&P 500 or the Dow, the fees are generally significantly lower as there is much less active management. Mutual funds however, are generally more actively-managed and therefore have higher fees associated with them. These fees can erode returns over time making it a possible detractor. The next major difference affects how they trade. Mutual funds trade only once at the end of the trading day and the price is generally made public around 5:00 p.m. EST. ETFs however trade like a stock and trade throughout the day, meaning the price fluctuates intra-day as opposed to having to wait until the end of the day. The final major difference is in relation to how much you need to invest in either investment vehicle. If you’re looking to invest in mutual funds, many have a minimum amount you need to start with. This can be as little as $500 or $1,000 and can go up from there. In addition, mutual funds often must be purchased through the given fund family. The nice thing about ETFs is that since they trade on the stock market there is no minimum to start investing in them; you simply buy the amount of shares you can afford. Since they trade like a stock, ETFs can be purchased through almost any brokerage. Finally, ETFs are generally more tax- efficient in how they handle sales.
Make Sure to Look Under the Hood
Is your head swimming yet? Now that you’ve established that you want to invest in either mutual funds or ETFs you need to do your homework to see what suits you best. This is where I will almost always reference my go-to source for mutual funds and ETFs – Morningstar. Morningstar is THE source to go to when you’re considering either of these options. It breaks down exactly how much it’ll cost you to invest in the given fund, which is important to an investor like me who is trying to be frugal and keep my costs down. My favorite section on Morningstar shows the Top 25 holdings of mutual funds and ETFs. The reason why this is vital is that it tells you what they hold in the fund. Don’t just go off the name of the fund to guide you to what you should invest in. For example, you can commonly find Apple or Google being held in a Value Fund when they’re anything but Value and are largely considered a growth stock. The moral is, as with any investment choice, do your homework before you decide which specific mutual fund or ETF you invest in.
What’s Your End Goal?
I’ve written about determining what you’re investing in before as well as setting a risk profile and investing in mutual funds or ETFs is no different. Investing in the stock market is best served when you have a long-term approach as opposed to making rash and emotional decisions. With that in mind, investing in an index fund will suit most investors. As opposed to a fund that picks specific stocks or bonds based off their given ideals, an index fund seeks to mimic the movements of a specific index and thus has lower fees and generally outperforms actively managed mutual funds over the long- term. Most times, but not always, an index fund will be in the form of an ETF and will enjoy lower fees and thus less erosion, in general, over the life of the investment. To make things better for you as the investor, many online brokerages offer a selection of ETFs that you can buy commission-free which is generally not something found with many mutual funds. Like I said previously, when you’re making your investment decisions make sure to do your homework before you invest in the stock market.
What’s your take on mutual funds? Do you invest in them or do you look for less actively-managed index funds? If you have any questions on investing, feel free to shoot me an email and I’ll do my best to help you.
Photo courtesy of: Paul Pasieczny