The difference between a Mutual Fund and an ETF

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I can count the number of times I have golfed on my fingers.  Before taking a swing, I look over the various clubs at my disposal.   I think to myself, each club has an extremely important purpose and I must choose very carefully.  No matter which club I choose a triple bogey lies in my future.

You can in a sense think of ETFs and Mutual funds as different golf clubs.  They are almost the same tool but can have times when one makes more sense than the other.  Both ETFs and mutual funds are pooled investments that can hold a variety of investments inside of them.  Most ETFs are passively managed, with fewer moves occurring inside relative to Mutual Funds.

One difference is that ETFs trade like a stock, so you can buy and sell during the trading day.  Mutual Funds calculate their NAV or Net Asset Value after the close of the market each day.  In golf terms, if a round of nine holes was a trading day and I was a mutual fund, I would only know my score after the round was done.  My friend ETF would keep track as we played.

Another differentiator is the cost.  ETFs are cheaper on average than mutual funds.  As you may suspect there is more than just cost to consider here.  Mutual fund’s higher expenses come with the benefit of teams of industry professionals and researchers looking to enhance their fund’s return and protect it from any holdings that become undesirable.

In essence, the ETFs take more of a set it and forget it approach.  ETF managers pick a target like a large stock index and try to replicate it as closely as possible.  Mutual Funds can be a little more flexible in their strategy as they are not strictly trying to keep the same weighting as an index.

So which fund should I put with which type of account?  If we look at nonqualified accounts, many people like that ETFs typically have fewer capital gains distributions at the end of the year.  This can mean less income to report.  However, if inside a retirement account, capital gains can be reinvested so no tax burden is realized.   An active trader may find ETFs better for a fast-paced trading style.  A passive investor may opt for Mutual Funds, knowing that there are fund managers looking to outperform market averages on their behalf.

At the end of the day both ETFs and Mutual Funds are good instruments to invest in the market.   If you would like to see how an ETF or Mutual Fund could enhance your portfolio, contact us.