Investing Basics: Mutual Funds vs. ETFs
Eileen St. Pierre, The Everyday Financial Planner
Mutual funds are one of the best ways for individual investors to create a diversified portfolio for a low initial investment. A mutual fund pools money from investors to construct a portfolio of stocks, bonds, real estate, or other securities, according to its charter. Each investor in the fund gets a slice of the total pie.
They have been around for a long time. According to Investopedia, the mutual fund industry can trace its beginnings back to the Netherlands in the 18th century.
Exchange-traded funds, or ETFs, have been available in the U.S. for over 20 years but recently have grown in popularity. They allow investors to achieve the same objective as mutual funds – diversification at low cost. They were originally set up to track indexes (passively managed) but in 2008 the U.S. Securities and Exchange Commission authorized the creation of actively managed ETFs.
But there are some differences.
- You buy and sell directly from the investment company.
- Your trade is executed at the end of the trading day.
- The trade price is always at Net Asset Value Per Share (NAV).
- NAV =(MV of Assets – Debts)/# Total Shares in Fund
- They trade just like shares of stock.
- You buy from or sell to other investors through a broker/dealer.
- You can sell short or buy on margin.
- Your trade can be executed at any time during trading day – you do not have to wait until end of day.
- The price can deviate from NAV.
The Bottom Line
There are different legal structures to ETFs so it can get a bit more complicated. But for individual investors trying to decide between a mutual fund and ETF, ask yourself these questions:
- Does the mutual fund/ETF satisfy my investment objective?
- Is it important for me to know with whom I am trading?
- Can I wait until the end of the trading day to execute my trade?
- Is the security of knowing my trade will be executed at NAV important to me?
Your answers to these questions should help point you in the right direction.