Having a well-diversified portfolio is one of the fundamental principles of investing since your winners can be offset by your losers when you own a broad range of stocks. So instead of putting all your eggs in one basket with just a few individual stocks, you can minimize your risk by buying shares of a mutual fund or an exchange-traded fund (ETF) that is pegged to several companies under a market index, industry sector or market cap. So whether you want to invest in the S&P 500 or a basket of large cap growth stocks, there is most likely a mutual fund or ETF for it.
But if you had to choose between a S&P 500 ETF or S&P 500 index mutual fund, which would you choose? Although they may mirror the same index, there are significant differences between the two, which can affect your returns.
Fees: Fees for mutual funds are higher than ETFs because mutual funds have more operational and management costs. The expense ratio for mutual funds can typically cost anywhere from 1% to 2% and includes management fees, transaction fees, distribution fees, marketing costs and other expenses. You’ll pay even more if you’re investing in a mutual fund that comes with a sales load, which is a commission for your broker or financial advisor.
On the other hand, the expense ratio for an ETF is typically around 0.5%. ETFs don’t have any 12b-1 or load fees, but you’ll have to pay a commission to buy or sell them, which can cost less than $20 per trade with an online broker. However, if you’re using a dollar cost averaging strategy or trading frequently, the commissions may eventually eat away at your returns.
Taxes: Due to the different structures of ETFs and mutual funds, the tax consequences will also be different. With an ETF, you can decide when to take a capital gain or loss by selling it whenever you want. Because ETFs are traded on an exchange, no underlying stocks need to be sold to raise cash for investors who want to redeem shares.
However with mutual funds, the fund manager can sell securities at any time to rebalance the fund or accommodate other investors who want to redeem their shares. Even if the fund is losing money overall, shareholders will own tax on any gains from these sales.
Accessibility: ETFs don’t require an initial investment like many mutual funds do. For example, you’ll have to have a minimum of $3,000 to start investing with a Vanguard 500 Index fund. But smaller investors who don’t have that capital can buy as many or few shares of Vanguard S&P 500 ETF (VOO) as they want. This is advantageous if you want to invest in many specific kinds of ETFs to have a more diversified portfolio. Without minimum requirements to invest, you can buy more ETFs that give you exposure to different markets, commodities or industries.
Trading Flexibility: In regards to trading, ETFs behave much like stocks. Investors can short ETFs, buy them on margin and trade them throughout market hours by looking at real-time bids and offers on an exchange. This allows investors to place a variety of orders with specific limits or stop loss orders to lock in at desirable prices.
With mutual funds, you never know what price you bought or sold them until the end of day when the net asset value is calculated, and this can hinder you from making your next investment decision. However, mutual funds trades only take one day to settle, in contrast to ETFs which take three days after the trade date to settle. The longer settlement process for ETFs can also hinder you from making your next move for your portfolio.
In conclusion ETFs have lower fees and are more tax-efficient, although brokerage commissions can cut into your return if you’re making frequent trades. ETFs are also more accessible for smaller investors because they don’t require an initial upfront investment like many mutual funds do. Without their money tied up in initial requirements for mutual funds, investors can also buy more different kinds of ETFs in order to have a diverse portfolio. Overall, ETFs have more trading flexibility, but they take longer to settle. Choosing between an ETF or mutual fund will largely depend on how much capital you have, your trading style and your personal investment objectives.
Hannah Kim is a financial writer at NerdWallet, a site dedicated to helping consumers learn how to manage their money, whether it’s to help them find the best credit card for their needs, or find the right online brokerage account.