If you are at all in tune with the market, you have probably noticed a large influx of people talking about, and investing in, exchange traded funds, or ETFs. Heck, if you turn on college sports on CBS, there are even commercials begging you to invest in specific ETFs. Mutual funds have been around for almost 100 years while ETFs are relatively new. The first ETF popped up in 1993, however, it is only as of the last decade or so where they have picked up steam. What is the difference between ETFs and mutual funds? Is one of them better than the other?
Both mutual funds and ETFs are ways of diversifying your holdings. Instead of buying shares of one company, by purchasing a share of one of these funds, you are owning part of many companies by investing in one holding. If one of the companies in the fund performs poorly, there may be 100 other companies that are part of the fund to pick up the slack.
In the broad sense, ETFs track an index, such as the S&P 500, NASDAQ, and others. Because they try to copy these indexes, there is very little management of the holdings, which means the expenses to own an ETF are minimal. Some mutual funds are actively managed where an individual, or a group of managers, changes the holdings within the mutual fund more often in hopes of beating the overall market. Sometimes this works, and other times managers fall short of their goal.
The biggest difference between mutual funds and ETFs is how they are traded. ETFs are traded just like an individual stock would be, such as Apple or Amazon. If you had $1,000 to invest in an ETF. We would need to figure out how much one share of the ETF is and how many shares you could buy, without going over $1,000. This would likely not get us to exactly $1,000, leaving some of the money uninvested. The nice thing about mutual funds is that you can purchase partial shares. If you have the same $1,000 you could purchase exactly $1,000 worth of the mutual fund, leaving none of the principal uninvested. You would end up with something like 12.62 shares of a mutual fund instead of a round number of shares of an ETF.
The other difference when it comes to trading is that ETFs can trade throughout the trading hours. If you wanted to purchase or sell shares of an ETF. That order would be placed as soon as we initiated it. Mutual funds, however, only initiate buy and sell trades at the end of the trading day. For instance, if you put in an order to purchase $1,000 worth of a mutual fund at 9:00 AM and by the time the market closed the price went up, your $1,000 would be buying you less than it would have at 9:00 AM. Although it sounds like a negative, the opposite could also be true. If the price drops during the day, your $1,000 could buy you more shares of the mutual fund, and in theory you would be getting it “at a discount”.
So, which option is the better choice? Although every situation is very different, there is a strong argument to be made that a combination of both ETF’s and mutual funds are both beneficial to have in one’s investment portfolio.