Exchange Traded Funds or ETFs have become the darling of the inventing world and they are giving mutual funds a run for their money. As much as both of them are viable investing choices, it is very important that as an investor, you familiarize yourself with the similarities and the differences both of them have to offer. With the right information, you can make an informed investment decision. This article discusses ETFs vs. mutual funds and will help you make that informed decision.
ETFs are index funds, which means that they are managed passively and track indexes. There are some ETFs that are managed actively but they function more like mutual funds and hence have higher fees. On the other hand, mutual funds are run by professional managers that attempt to beat the market. Due to the active management, mutual funds tend to have higher costs.
Some people think it is worth paying for the professional management and hence go with mutual funds but research indicates it is not. Funds that are actively managed rarely beat the market and as an investor, you have better chances of higher returns when you invest in low-cost index funds like ETFs.
It’s a fact that ETFs are index funds but they come with a twist. ETFs are traded like stocks through the day and their prices are normally based on demand and supply. On the other hand, mutual funds are priced and traded at the end of every trading day.
Due to the fact that ETFs are like stocks when investors buy or sell, they pay some commissions. Nowadays, however, there are some brokerages that offer commission free ETFs and you should choose a few of these when investing. The commissions might not seem much but if you invest every month, it will add up very fast.
When investing in commission-free ETFs, you should consider the expense ratio because some of these funds have high expenses in order to make up for commissions. When investing with ETFs, keep in mind that they are not meant for day trading, you have to hold on to yours for a given number of days or you will be charged.
The expense ratio is what indicated how much an investor pays every year in order to own a fund as a percentage of what they invested. ETFs are considered quite inexpensive with some of them carrying expense ratios of 0.01%, which means an investor pays $1 for every $1,000 they invest each year.
However, you should not assume that this means they are the cheapest option out there. Index funds, for instance, are worth considering but in general, mutual finds higher expense ratios than both index funds and ETFs.
ETFs are a lot of tax efficient compared to mutual finds due to the way they are managed. This is important to consider if the exchange traded fund is within a taxable account and not in a retirement account, which can be tax-advantaged like 401(k) or IRA.
THE STARTING MINIMUMS
Mutual funds can have very high entry costs that could even be a minimum of $1,000. However, ETFs are usually purchased by a share and this makes them inexpensive.
This might be the one area ETFs fall short. Despite the fact the ETFs have really grown in popularity, there are more mutual funds available. You will find an ETF that meets your needs but you will not have a lot to select from compared to mutual funds.
Liquidity is normally measured by the trade volume. If the interest is low and the trading volumes are low then the spread increases. These forces sellers to offer price discounts so they can get the security sold and causes the buyers to pay price premiums. ETFs are somewhat immune to this because their liquidity is not influenced by trading volumes. ETFs liquidity is influenced by the liquidity of the stocks included on that index.
As an investor, you should not assume that all investments are low cost. Ensure you consider all potential fees even for ETFs. They are inexpensive compared to mutual funds but you still need to know what you are doing. All in all, if you are looking for the better option, you need to consider all these aspects and decide which one will work best for you.