An investor's portfolio may include stocks, bonds, and sectors with value or growth options, and investors commonly decide whether a mutual fundor exchange-traded fund (ETF)meets their financial goals.
Mutual funds and ETFs can hold portfolios of investments like stocks, bonds, or commodities. They both adhere to the same regulations, like what they can own or how much can be concentrated in one or a few holdings.
Key Takeaways
- Mutual funds and ETFs may hold stocks, bonds, or commodities.
- Both can track indexes, but ETFs tend to be more cost-effective and liquid since they trade on exchanges like shares of stock.
- Mutual funds can offer active management and greater regulatory oversight at a higher cost and only allow transactions once daily.
Choosing ETFs
Exchange-traded funds trade on exchanges just like common stocks. Most ETFs are index-tracking and aim to match the returns and price movements of an index, such as the , by assembling a portfolio that matches the index constituents.
Passive management generally makes ETFs cheaper than mutual funds with lower expenses than index-tracking mutual funds. Because buyers and sellers are doing business with one another, the managers have far less to do. The ETF providers want the price of the ETF to align as closely as possible to the net asset value of the index. To do this, they adjust the supply by creating new shares or redeeming old shares.
In Jan. 2024, the Securities and Exchange Commission(SEC) approvedthe firstspot marketbitcoinETFs listed on theNYSE Arca,Cboe BZX, andNasdaqexchanges.
Benefits of ETFs
- Buying and selling can occur at any point during a trading session at market pricing.
- ETFs are not priced at the end of the day.
- There’s no minimum holding period. This is especially relevant in the case of ETFs tracking international assets, where the price hasn’t yet been updated, but the U.S. market’s valuation of it has.
- ETFs can reflect the new market reality faster than mutual funds can.
- Investors in ETFs and mutual funds are taxed based on the gains and losses incurred within the portfolios. ETFs engage in less internal trading, and less trading creates fewer taxable events.
Investors only pay capital gains taxes when they sell ETF shares. By holding on to shares, investors delay paying taxes until shares are sold.
Mutual funds are commonly managed by financial institutions such as Vanguard, T. Rowe Price, and BlackRock, either directly or through a brokerage firm. The purchase of a mutual fund is executed at the net asset value of the fund based on its price at the market close.
When investors sell shares, the same process occurs, but in reverse. Some mutual funds assess a penalty of up to 2% of the shares’ value for selling early, typically sooner than 90 days after purchase.
Mutual funds can track indexes, but most are actively managed. Actively managed funds incur high costs for analysts, economic and industry research, company visits, and administration. That typically makes mutual funds more expensive to run—and for investors to own—than ETFs.
Benefits of Mutual Funds
- Mutual funds can be purchased in fractional shares or fixed dollar amounts.
- Minimum initial investments for mutual funds are a base dollar amount and not based on the fund's share price.
- Investors benefit from professional managers when the fund is actively managed.
When Does a Taxable Event Occur for an ETF?
For an all-ETF portfolio, the tax will generally be an issue only if and when investors sell their shares. Just like mutual funds, if an ETF pays dividends, those count as taxable income.
When Are Investors Liable for Gains Earned from a Mutual Fund?
Unless individuals invest through 401(k) or other tax-favored vehicles, mutual funds will distribute taxable gains to investors, even if they merely hold the shares.
What Is Meant by an Open-End or Closed-End Fund?
Mutual funds and ETFs are both open-ended. The number of outstanding shares can be adjusted up or down in response to supply and demand. A closed-end fund (CEF) does not continuously offer its shares for sale but instead sells a fixed number once.
The Bottom Line
ETFs and mutual funds are baskets of individual securities like stocks or bonds. Both offer exposure to a variety of asset classes. Investors can gain more diversification from a mutual fund or ETF than investing in a single stock or bond.
FAQs
Mutual funds and ETFs may hold stocks, bonds, or commodities. Both can track indexes, but ETFs tend to be more cost-effective and liquid since they trade on exchanges like shares of stock. Mutual funds can offer active management and greater regulatory oversight at a higher cost and only allow transactions once daily.
Is it better to invest in ETFs or mutual funds? ›
The choice comes down to what you value most. If you prefer the flexibility of trading intraday and favor lower expense ratios in most instances, go with ETFs. If you worry about the impact of commissions and spreads, go with mutual funds.
What is the downside of ETFs? ›
For instance, some ETFs may come with fees, others might stray from the value of the underlying asset, ETFs are not always optimized for taxes, and of course — like any investment — ETFs also come with risk.
Is S&P 500 a mutual fund or ETF? ›
An index fund is a type of mutual fund that tracks a particular market index: the S&P 500, Russell 2000, or MSCI EAFE (hence the name). Because there's no original strategy, not much active management is required and so index funds have a lower cost structure than typical mutual funds.
What is more expensive ETF or mutual fund? ›
ETFs expense ratios generally are lower than mutual funds, particularly when compared to actively managed mutual funds that invest a good deal in research to find the best investments.
Why would you want a mutual fund over an ETF? ›
Unlike ETFs, mutual funds can offer more specific strategies as well as blends of strategies. Mutual funds offer the same type of indexed investing options as ETFs but also an array of actively and passively managed options that can be fine-tuned to cater to an investor's needs.
Are ETFs good for beginners? ›
Exchange-traded funds (ETFs) are ideal for beginning investors due to their many benefits, which include low expense ratios, instant diversification, and a multitude of investment choices. Unlike some mutual funds, they also tend to have low investing thresholds, so you don't have to be ultra-rich to get started.
What is the best ETF to buy right now? ›
The best ETFs to buy now
| Exchange-traded fund (ticker) | Assets under management | Expenses |
|---|
| Vanguard 500 Index ETF (VOO) | $432.2 billion | 0.03% |
| Vanguard Dividend Appreciation ETF (VIG) | $76.5 billion | 0.06% |
| Vanguard U.S. Quality Factor ETF (VFQY) | $333.3 million | 0.13% |
| SPDR Gold MiniShares (GLDM) | $7.4 billion | 0.10% |
1 more rowAt least once a year, funds must pass on any net gains they've realized. As a fund shareholder, you could be on the hook for taxes on gains even if you haven't sold any of your shares.
Do ETFs pay dividends? ›
Key Takeaways. ETFs pay dividends earned from the underlying stocks held in the ETF. An ETF that receives dividends must pay them to investors in cash or additional shares of the ETF. Dividends may be taxed at the long-term capital gains rate or the investor's ordinary income tax rate.
The short answer is that it depends on the specific ETF or mutual fund in question. In general, ETFs can be more risky than mutual funds because they are traded on stock exchanges.
Which gives more return, ETF or mutual fund? ›
ETFs offer tax advantages to investors. As passively managed portfolios, ETFs (and index funds) tend to realize fewer capital gains than actively managed mutual funds.
Is ETF tax free? ›
Profits from ETF holdings of over 3 years are categorised as long-term capital gains. The ETF tax rate for these gains is 20% (with the benefit of indexation). The profits, if any, from these ETFs are always considered to be short-term capital gains. They are taxed at the applicable income tax slab rate.
Are ETFs better for taxes than mutual funds? ›
ETFs are generally considered more tax-efficient than mutual funds, owing to the fact that they typically have fewer capital gains distributions. However, they still have tax implications you must consider, both when creating your portfolio as well as when timing the sale of an ETF you hold.
Is ETF good for long term? ›
Units of such ETFs can be held for a long term as a part of the core portfolio. Investors can also use these ETFs to complement their trading or investment style to achieve diversification. For example, an aggressive trader going after momentum trades, can park some money in the units of low volatility ETF.
Is it better to buy stocks or buy ETF? ›
ETFs offer advantages over stocks in two situations. First, when the return from stocks in the sector has a narrow dispersion around the mean, an ETF might be the best choice. Second, if you are unable to gain an advantage through knowledge of the company, an ETF is your best choice.
