The Difference Between Mutual Funds and ETF’s

shutterstock_415332415

If you’re like most investors, you probably have at least some kind of experience with mutual funds. A 401k or 403b company sponsored retirement plan uses mutual funds almost exclusively as an investment vehicle while most people use mutual funds for their IRA or Roth IRA. Beginning investors tend to start out with mutual funds as a way of gaining experience in the stock market and build up starting capital before opening up a brokerage account to trade stocks as well.

But mutual funds haven’t delivered the kind of performance that investors have been seeking over the past decade or so. Management fees and sub-par portfolio gains have led to a massive exodus away from mutual funds into exchange-traded funds (ETF’s) where investors have more direct control over their portfolio’s and pay fewer fees along with it.

In 2015, Wall Street saw $150 billion leave the mutual fund industry while ETF’s saw inflows of $150.6 billion. Investors are viewing ETF’s as better alternatives to mutual funds despite the fact that the mutual fund industry is by far larger with $11.5 trillion in assets under management whereas ETF’s have only $2.1 trillion. But before you jump ship from mutual funds into ETFs in order to chase better gains and lower fees, there are some stark differences that you need to know.

A side-by-side comparison between Wall Street’s favored investment vehicles

Mutual funds are actively managed, diversified investment vehicles that are designed to track a specific benchmark. They usually have a team of analysts that make stock selections for the portfolio and have the ability to make adjustments throughout the year as the economic environment changes.

Mutual fund strategies are usually given away by their name. Take a hypothetical fund we’ll call XYZ Blue Chip Growth Fund. Just from the name, we know that this fund invests in large cap companies and takes a growth investment strategy into account when making its stock selections. Management will do its best to track an index that follows along the blue chip growth stocks and will charge investors a fee for doing so.

At first glance, ETF’s look to be very similar to mutual funds. Most are designed to track a specific index and hold a basket of stocks in its portfolio. But ETF’s are passively managed meaning no manager will track the individual stocks or make adjustments to the portfolio. They come with lower fees than a mutual fundĀ  but run the risk of holding poor stocks in the mix.

ETF’s are more liquid than mutual funds though. Mutual funds trade once per day at the end of the day while ETF’s trade much like stocks do. But ETF’s with low trade volume can present a problem for investors with higher intra-day volatility.

Final considerations

Once you start to branch out in your investment experience, you’ll find that there are a lot of vehicles out there for you to pick from. Trading individual stocks after only holding mutual funds can be a stressful endeavor especially if you aren’t used to high levels of volatility in your portfolio. While some investors are favoring ETF’s over mutual funds, others look to ETF’s as a way to bridge the gap between funds and stocks. Using ETF’s for diversification purposes or as a way to slowly dip your feet into the market can be helpful.

Both ETF’s and mutual funds have a place in an investment portfolio and shouldn’t be viewed as an either/or scenario. A healthy balance of both is the key to maintaining a successful investment account.