So, you’ve seen the light, abandoning the hubris of a Wolf of Wall Street fantasy. You’ve decided to steer clear of being among the 99% of stock traders who underperform indices, opting instead to become the index.
Smart move. No longer will you need to pour over financial statements for the slim chance of outperforming the market by 1%; index investing offers diversified, stable, and relatively reliable market returns from an investment strategy that demands as little as 5 minutes a month of your time—if you’re slow.
Feels liberating, doesn’t it?
But just as you cast aside your internal struggle with greed, you find yourself at another crossroads! Should you invest in mutual funds or ETFs? What’s the difference between ETFs and mutual funds?
This decision often stumps novice investors. After all, the term “index fund” applies to both ETFs and mutual funds, blurring the distinction between the two. It’s crucial to also grasp the difference between SPX and SPY, or an index and an ETF.
Step 1) Understand the Difference Between Mutual Funds and ETFs
Mutual Funds: The old-school index funds. The “mutual” in their name comes from their structure. For investors with limited funds, buying enough shares of different companies to be fully diversified can quickly become expensive. Imagine the cost of purchasing one share from each of the roughly 4,000 companies listed on major U.S. exchanges, not to mention the thousands more traded internationally.
To tackle this challenge, our investment forebears devised a solution. Investors pool their money, allowing them to invest in a more diversified portfolio than they could achieve alone, then share the gains and losses. Kids, that’s how mutual funds were born.
At the end of each trading day (4:00 PM Eastern Time), the total value of all the assets the fund holds is tallied up and assigned a fund value (divided by its number of shares). At this point, investors can buy or sell more shares.
ETFs: Stands for Exchange-Traded Funds. ETFs function very similarly to mutual funds in that they pool money to buy a large number of underlying assets for diversification.
Unlike mutual funds, which calculate their value once a day, ETFs trade like regular stocks. This means their price changes throughout the day, and they can be bought at any time. There are various types of ETFs, such as carbon ETFs, so you won’t be short on options.
That’s it. That’s the only difference between these two index options.
However, this slight difference does indeed bring some practical distinctions for you (the investor), and depending on your situation, one option might be better than the other. We’ll get to that in a bit.
Step 2) Relax.
Much like choosing a retirement account, deciding between mutual funds and ETFs is akin to deciding whether dessert should be cheesecake or chocolate cookies. Both are good choices that can make you happy (and wealthy) in the wallet.
Step 3) Find the Right Type of ETF or Mutual Fund.
In the debate between ETFs and mutual funds, perhaps the most critical step is making sure we’re not being duped.
Many mutual funds and ETFs are actively managed, but that’s not what we want. Actively managed mutual funds/ETFs continuously trade in an attempt to beat the market, but at least 85% underperform the index. A resounding “no” to that.
We also don’t want anything with sales charges. In the mutual fund world, sales charges go by many unsavory names, such as:
- 12-b1 fees
- Loads
- Front-end loads
- Back-end loads
Under no circumstances should you invest your money in funds that charge these fees. Never.
If you’re about to invest in high-fee funds with your computer, I will come to your house and hit you over the head with your laptop. The fees are that atrocious.
What we’re looking for are quality mutual funds or ETFs that are passively managed and track broad indices like the S&P 500, Dow Jones, or the entire stock market.
Overall, we want something with low fees and low turnover, like Vanguard’s Total Stock Market Index Fund or its ETF equivalent, Vanguard Total Stock Market ETF.
So we know we’re not being swindled, but the question remains. Is investing in mutual funds or ETFs more advantageous?
Step 4) The Actual Differences Between ETFs and Mutual Funds.
Remember, ETFs trade like stocks, while mutual funds are more like bank accounts. This tiny distinction does indeed bring some pros and cons for you (the investor):
Pros of ETFs:
- Typically, ETF expense ratios are lower than mutual funds, especially for smaller investment amounts.
- ETFs usually have lower minimum investment amounts (often the price of one share).
- Can be bought and sold at any time during the day.
- Allow for more complex investment choices, like short selling and margin buying. (Not recommended for beginners. Here’s a list of best brokers for short selling.)
Cons of ETFs:
- Because ETFs trade like stocks, each transaction incurs normal brokerage commissions. (Typically $5-10 per trade, depending on your broker)
- Buying ETFs is subject to bid-ask spreads, but for large ETFs, this spread is usually only about a penny per share.
- No automatic investment option.
- Can only be bought in whole shares. (If you want to invest 80,𝑏𝑢𝑡𝑡ℎ𝑒𝑠𝑡𝑜𝑐𝑘𝑝𝑟𝑖𝑐𝑒𝑖𝑠100, you’ll need to find an extra $20 under your couch cushion.)
Pros of Mutual Funds:
- No transaction costs, as mutual funds don’t trade like stocks, and you don’t need a broker. (You can buy directly through the mutual fund company, like Vanguard.)
- Automatic investment options available.
- Can be bought in fractional shares. (If you want to invest 80,𝑎𝑛𝑑𝑡ℎ𝑒𝑠𝑡𝑜𝑐𝑘𝑝𝑟𝑖𝑐𝑒𝑖𝑠100, you’ll get 0.8 shares credited to you and allocated returns accordingly.)
Cons of Mutual Funds:
- Typically have higher minimum investment amounts, ranging from 1,000𝑡𝑜10,000.
- Can only be bought and sold once a day.
Mutual Funds vs. ETFs – Final Thoughts
If you’re starting to invest with a lack of substantial funds, ETFs are a great option.
For just the price of one share of Vanguard’s Total Stock Market ETF (at the time of writing this article, 119.03),𝑦𝑜𝑢𝑐𝑜𝑢𝑙𝑑𝑖𝑛𝑣𝑒𝑠𝑡𝑖𝑛𝑜𝑛𝑒𝑜𝑓𝑡ℎ𝑒𝑚𝑜𝑠𝑡𝑐𝑜𝑚𝑝𝑟𝑒ℎ𝑒𝑛𝑠𝑖𝑣𝑒,𝑑𝑖𝑣𝑒𝑟𝑠𝑖𝑓𝑖𝑒𝑑𝑖𝑛𝑑𝑒𝑥𝑓𝑢𝑛𝑑𝑠𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒,𝑎𝑛𝑑𝑦𝑜𝑢𝑟𝑜𝑛𝑙𝑦𝑐𝑜𝑠𝑡𝑠𝑤𝑜𝑢𝑙𝑑𝑏𝑒𝑡ℎ𝑒𝑎𝑝𝑝𝑟𝑜𝑥𝑖𝑚𝑎𝑡𝑒8 purchase commission and the negligible ongoing expense ratio of 0.05%.
On the other hand, the $8 brokerage fee is a significant expense for those regularly contributing to their index fund. The ability to buy additional shares of a mutual fund without any transaction fees is a huge advantage, and the ability to automatically invest in mutual funds and buy fractional shares is a great option for those planning to contribute regularly.
Furthermore, the low-cost advantage of ETFs tends to be short-lived. For example, once your balance accumulates above $10,000, Vanguard reduces the expense ratio of the mutual fund to match that of the corresponding ETF’s expense ratio.
We’ve discussed a lot of details in this article, so let’s get to the point in a cheaty way.
Mutual Funds vs. ETFs – Cheat Sheet
Suited for ETF investment:
- You have only a small amount of money to invest, and you’re not going to hit the account balance to lower the mutual fund’s fees to its ETF counterpart anytime soon.
- You’re an active stock trader planning to do some wild stuff with your ETF throughout the day.
(Choose the best ETF broker)
Suited for mutual fund investment:
- You have enough funds to invest to ensure you’re getting the lowest fees.
- You plan to make regular contributions to increase your investment.
- You want to set up automatic investments by a predetermined amount into your investment.
But most importantly, perhaps the most crucial consideration is not to be paralyzed by analysis.
Regardless of which path you choose, you’re making a great investment decision that will likely far outperform those fancy stock traders. Remember, we’re choosing between cheesecake and chocolate cookies here. If you want diversification, consider adding some fractional real estate ownership into your portfolio.
Now, go and fatten your wallet.