I get this question a lot from clients – what’s the difference between mutual funds and ETFs (exchange-traded funds)? Both are investment funds that will generally provide you with some level of diversification. There are mutual funds and ETFs that invest in US stocks, non-US stocks, real estate, and gold. Additionally, there are even funds that allow you to invest in more developing areas like cannabis and blockchain technology. While mutual funds and ETFs have several similarities, I’ll point out three of the major differences.
Mutual Funds and ETFs
Buying and Selling Shares
If you want to invest in a mutual fund, you’ll need to buy shares directly from the fund company. Mutual funds are pricing happens once per day. When you want to sell your shares of a mutual fund, you’ll redeem them with the fund company, and they will pay you whatever the share value is on that day.
The “E” in ETF stands for exchange. If you want to purchase shares of an ETF, you’ll need to find someone willing to sell your shares. To do this, you’ll make the purchase on an exchange, like the NASDAQ or the New York Stock Exchange. You can do this at any point during the day when the markets are open. Throughout the day, the price of the shares of an ETF may fluctuate.
When you go to sell your shares of a mutual fund back to the fund company, the fund manager may not have the cash available to give you. In this case, the fund manager needs to raise cash by selling some of the investments they’ve made inside of the fund. This transaction may generate taxable gains, which then distribute out to the mutual fund shareowners. If you own shares in a mutual fund, chances are you’ve received a Form 1099-DIV from that fund company, typically around February. Any capital gains the fund realized during the year were passed along to you, the shareowner, to pay taxes on. This means even in a year in which you didn’t sell anything; you can still be liable for capital gains taxes.
Many regard exchange-traded funds as more tax-efficient investments than mutual funds. In this example, Jim and Sally both own shares of an ETF. Jim wants to sell his shares, and Bob wants to purchase his shares. Bob buys his shares directly from Jim to complete the transaction. Notice how a fund manager wasn’t involved, and no investments inside the ETF needed to be sold. There were no capital gains realized inside the fund. Jim, who sold his shares, may need to pay tax on any capital gain he realized. Additionally, Sally will not have a tax liability due to Jim’s sale to Bob.
Costs Between Mutual Funds and ETFs
Both mutual funds and ETFs will typically have costs, and the cost is usually an expense ratio. An expense ratio is stated as a percentage. Actively-managed funds will often have higher expenses than passively-managed funds. Actively-managed funds will typically have a team of fund managers and investment professionals whose stated objective is to outperform a benchmark like the S&P 500 or the Bloomberg Barclays US Aggregate Bond Index. It costs money for the fund company to pay their managers, market the fund, and research investments. Those costs are usually passed along to the shareowners.
With a passively-managed fund, the fund is typically not trying to outperform a benchmark but to replicate the performance of a benchmark. The cost of doing business within a passively-managed fund is usually lower.
Many mutual funds are actively-managed, although there are some mutual funds that are passively-managed. A typical expense ratio for an actively-managed mutual fund might be 0.75% or higher, meaning for every $100,000 you invest in the fund, you’ll pay about $750 per year in fund expenses. On the other hand, ETFs are generally passively-managed, and usually, have lower expense ratios of below 0.4%.
If You’re Not Sure, Talk to a Professional
Both mutual funds and ETFs can play an essential role in your portfolio. You should consult with your financial planner to determine which may be the best investment vehicle to accomplish your goals. If you want to learn more about mutual funds and ETFs – you can check out The Guided Retirement Show episodes 12 and 13. In these episodes, Dean Barber, Bud Kasper, and I discuss the differences of mutual funds and ETFs and how they can fit in a retirement plan.
You can also reach out to us anytime at 913-393-1000 or schedule a complimentary consultation below. We’re always ready to discuss your financial planning options and the impact they might have on your retirement.
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The views expressed represent the opinion of Barber Financial Group an SEC Registered Investment Advisor. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Barber Financial Group does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.