When it comes to popular diversified investment options, most investors would do well to invest in exchange traded funds (ETFs) or mutual funds. ETFs and mutual funds are essentially two sides of the same coin, offering options and flexibility to investors.
Exchange Traded Funds: Track the price of a basket of stocks (an index) and follow the price up or down. This is generally what people mean by “investing in the market.”
Mutual Funds: A fund manager decides on an investment strategy and pools money from investors to trade individual stocks that fit within that strategy.
Both ETFs and mutual funds are baskets of investments that allow investors to hold bundles of stocks, bonds, commodities, currencies—pretty much any type of investment. This is mainly because ETFs evolved from mutual funds as investors started looking for slightly different features. ETFs and mutual funds are more diversified than individual securities, effectively eliminating unsystematic risk (risk that is unique to a specific company or industry).
While there are many similarities between ETFs and mutual funds, it helps to know the differences as well.
Mutual funds, on the other hand, only set their price once a day at the end of the trading day. Their price is calculated as: the total value of the portfolio divided by the number of shares—otherwise known as net asset value (NAV).
The average mutual fund carries an expense ratio of 0.74 percent, while the average ETF’s expense ratio is 0.44 percent. The reason for lower expense ratios for ETFs is that ETFs are usually passively managed and thus do not have active management fees.
The small differences between ETFs and mutual funds can dictate what an investor will choose to invest in. Generally speaking, ETFs are a better choice for inexperienced investors for a few reasons.
ETFs have lower minimums and thus a lower barrier to entry for new investors who may be unsure of how much money they can invest. Investors will also not get frustrated with high or hidden fees, which can happen with other investment types. ETFs can be bought or sold at any point in the day when markets are open, providing more flexibility and real time data than mutual funds.
In recent years, there has been an expansion in the types of ETFs available due to high investor demand.
Passive ETFs are more traditional ETFs that track a popular index without any special investment strategy. For example, the S&P 500 (one of the most well-known indexes) is made up of the 500 largest public companies in the US. Many investment brokerages like Schwab, Vanguard and Fidelity offer their own versions of passive ETFs that track the S&P 500. Robo-advisors are investment companies that use computer algorithms and a simple questionnaire to invest in passive ETFs based on an investor’s risk level.
Active ETFs are more deliberate in their selections based on a specific strategy. For example, there are active ETFs focused on industry sectors like energy or tech, high paying dividend stocks, real estate, and more. These active ETFs may outperform the market, but usually charge higher fees than passive funds.
If you are interested in professionally managed funds, mutual funds may give you access to that alpha for a relatively low cost. Mutual funds are less risky than buying individual stocks and provide hundreds, if not thousands, more options to choose from. Investing in mutual funds can be a great strategy for people who are saving for long term goals like college education and retirement.
ETFs can offer many of the benefits of mutual funds for a fraction of the cost and investment. They are also typically easier to invest in than mutual funds and thus are more popular investments for younger investors. As with all other investment decisions, it is good to reflect on what your personal needs and goals are before choosing an investment type to proceed with.