ETFs vs. Mutual Funds: Which Is Better for Investors?

What are ETFs?

Exchange-traded funds (ETFs) are a basket of securities that track the performance of stock market benchmarks such as the Dow Jones Industrial Average (DJIA) and/or the S&P 500. The S&P 500 ETFs are designed to duplicate their performance.

These funds trade on the stock market like stocks and bonds and are traded throughout the day. There is a wide variety of ETFs available for every asset class. And investors can find an ETF that covers pretty much every asset class whether it’s equities or real estate.

One of the prime reasons why ETFs have grown in popularity is their low-cost advantage to investors. Their expense ratio is very low, compared to other asset classes. Also, ETFs are passive, tracking an index, which means less turnover and low taxable events.

ETFs are overall attractive investment options for regular investors. The ease of buying it offers which provides vast exposure makes it a preferred choice of investment for the majority of investors.

Types of ETFs

ETFs can be broken down into different categories, according to the asset classes, investment style, sector, strategy, or regional exposure.

The main types of ETFs include:

Equity ETFs – Equity ETFs, also known as stock ETFs, typically track an index of stocks, such as the S&P 500 index. These types of ETFs are broadly categorized by market capitalization, investment style, investment strategy, and regional exposure
Fixed Income ETFs – Commonly known as bond ETFs, fixed income ETFs typically track an index of bonds. Fixed-income ETFs are primarily categorized by the average duration or maturity of the fund’s holdings, and by issuer type, credit quality, yield, or regional exposure.
Commodity ETFs – Commodity ETFs track the price movement of an underlying commodity or index of commodities, such as oil ETFs, gold, or agricultural products. Some of these ETFs also track an index representing a basket of many commodities. These ETFs can be categorized by strategy, including physically backed funds, futures-based funds, equity-based funds, and ETNs. Checkout: ETF vs ETN.
Currency ETFs – Currency ETFs invest in different currencies. Investors profit from the price movements.
Multi-asset ETFs – Multi-asset ETFs are exchange-traded funds that invest in more than one asset type, such as a mix of stocks and bonds, generally intended to create a diversified portfolio within a single fund. Many multi-asset ETFs are made up of other ETFs to create one portfolio.
Alternatives ETFs – Alternative ETFs offer investors access to areas of the market that may otherwise not be accessible to them.
Sustainable ETFs – Also known as ESG ETFs, sustainable ETFs are exchange-traded funds that typically track the performance of an index of stocks or bonds issued by companies that have certain environmental, social, and governance characteristics.

Advantages and Disadvantages of ETFs

Some of the attractive features of ETFs are:

More liquid– ETFs can be bought and sold at any time during open market hours. Investors can also control the price as well.
Cost-effective – ETFs are less expensive than mutual funds because they are passively managed. They charge a lesser expense ratio.
Less tax burden – ETFs are comparatively more tax-efficient
Lower investment minimums – Investors can easily buy a share of an ETF for a very low amount, as low as $ 1.
Better for short-term trading – Investors can buy and sell the best ETFs throughout the day. They are a good investment option for short-term trading.
Broad market exposure – Because ETFs are commonly index funds, ETFs usually give exposure to the whole index they are mirroring. Energy ETFs are also one of the best investment opportunities.

Read: ETFs vs Index funds, where should you invest?

While ETFs have some benefits, there are some downsides to it also:

Overexposure – These funds follow an index. And the index does not really hold the best stock for investment.
Lack of Rebalancing – Most ETFs don’t rebalance their portfolios. When the market rises, the price of certain stocks of the index rises while some fall. This results in the investor holding a basket of either over-priced or underpriced stock.

What are Mutual Funds?

A mutual fund is an investment vehicle in which a pool of investors collectively put forward funds to an investment manager to make investments on their behalf. Mutual funds may invest in stocks, bonds, money market instruments, or other assets. An investor earns proportionally to the amount of money invested in the mutual fund. Mutual funds and stocks each offer specific types of advantages to investors.

What makes mutual funds an attractive investment vehicle is the diversified exposure an investor earns spread across multiple industries and different asset classes. Also, it provides investors with an opportunity to benefit from a professionally managed investment portfolio.

The returns of a mutual fund are based on the performance of the assets it has invested in. For that, the portfolio of a mutual fund has to be carefully selected in order to provide a good return. Therefore, highly-trained professionals function as fund managers for mutual funds.

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Types of Mutual Funds

Broadly there are four types of mutual funds. They are as follows:

Equity Mutual funds: Equity mutual funds consist of stocks of companies. Examples of equity mutual funds are growth funds. They are focused on stocks of companies with significant growth potential in the future.
Money Market mutual funds: Money market mutual funds invest in short-term debt issued by corporates, governments, states, and municipalities. An example of such funds is an investment in US treasuries and debt issued by established companies like Apple Inc. or Exxon. The aim of this type of mutual fund is to generate income while minimizing risk.
Bond funds: Bond funds are considered conservative investments. These funds provide fixed income to investors. Like money market mutual funds, the investment portfolio of these funds is also limited to government and corporate debt. These funds are best suited for retirement planning.
Balanced Funds: Balanced funds are funds that aim to build a balance between equity and bond investing. They are long-term funds that incorporate a mix of stocks and bonds. An example of such a stock is 60% stocks and 40% bonds. For example, they might incorporate a more conservative approach close to retirement.

Advantages and Disadvantages of Mutual Funds

Some of the benefits of investing in mutual funds are:

Liquidity – Unless investors choose close-ended mutual funds, all mutual funds can be easily bought and sold as they have a high demand.
Diversification – Mutual managers select a portfolio of stocks with companies spread across various industries and different sectors.
Professionally managed portfolio – Mutual funds are managed by professional managers. Therefore, by investing in mutual funds investors get a professionally managed fund.
Easily buy fractional shares – Investors can purchase fractional shares of mutual funds. This means they can invest low amounts of money.
Quick and Hassle Free– Mutual funds provide a quick and efficient way of investing in multiple companies with just one purchase

There are also some disadvantages of investing in Mutual Funds, which are:

High cost – Since mutual funds are professionally managed funds, their expense ratio is comparatively high.
Dilution – In case of loss, the diversified portfolio can also erode away all profits.

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Similarities and Differences Amongst ETFs and Mutual Funds

Differences between ETFs and Mutual Funds

	ETFs	Mutual Funds
Investing Style	Often passive	Often active
How It Trades	Open market	Via the fund’s parent company
Taxes	More efficient	Less efficient
Expense Ratios	Often less expensive	Often more expensive
Trade Types	Complex types allowed	Only simple buy/sell orders
Investment Minimums	None	Often
Automated Investing	Usually not allowed	Usually allowed

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ETFs and mutual funds both offer more diversification than buying an individual stock.

ETFs are more passively managed stocks. They don’t need a team of professionals to manage the funds. These funds simply track an underlying index. Mutual funds, on the other hand, are more actively managed funds. A team of managers is carefully selecting the portfolio and keeps a check on all of them.

ETFs trade on the open market like stocks of regular companies. Whereas investors interested in investing in mutual funds have to buy shares through the fund’s parent company.

ETFs are more tax efficient. As long as investors don’t realize the profits by selling their investments, they don’t have to pay taxes.

Mutual funds also are required to distribute capital gains. As a result, the investors are illegible for paying taxes on the capital gain amount.

Since ETFs are passively managed funds that mirror the performance of market indexes, they do not require a team of professionals to manage the portfolio. Therefore, the expense ratio is comparatively low.

Whereas, mutual funds portfolio needs to carefully select its portfolio of stocks which needs to be actively managed. Therefore, they have a comparatively high expense ratio.

Similarities between ETFs and Mutual Funds

Great sources of diversification – ETFs and mutual funds both offer investors a diversified portfolio. Whichever funds investors choose, they are investing in a variety of stocks or bonds all at once.
Professional management – Both types of funds are managed by professional managers who use their expertise to make decisions about which securities to own.
Multiple investment options – There is a very broad range of different types of mutual funds and ETFs available to purchase. Investors can choose to invest in their chosen market, industry, and/or sector.
A great choice for long-term investors – For long-term investors who are saving for retirement or other goals, mutual funds and ETFs, both are good options. Long Term ETFs are one of the best options.

Also, learn:

ETF vs. Mutual Fund: Which is a Better Investment?

It is a difficult decision as they both have many differences and multiple similarities.

The decision to invest in which eventually depends upon the following factors:

Decide on a management style – Which management style an investor chooses also matters. Both ETFs and mutual funds can be passively managed, but there are also actively-managed funds available.
Investment Goal – Before investing, investors should consider their financial goals and target time horizon. If they are planning to invest for the long run, then investing in broad funds is a good approach. However, if investors need the money in the next few years, a more conservative fund that invests in bonds or lower-risk securities is more appropriate.

ETFs vs. Mutual Funds: Which Is Better for Investors?

What are ETFs?

Types of ETFs

Advantages and Disadvantages of ETFs

What are Mutual Funds?

Types of Mutual Funds

Advantages and Disadvantages of Mutual Funds

Similarities and Differences Amongst ETFs and Mutual Funds

ETF vs. Mutual Fund: Which is a Better Investment?

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