Exchange-traded funds, or ETFs, and mutual funds are often used interchangeably because they share many similarities and can achieve the same crucial investment goal: diversifying your portfolio.
Both allow investors to buy a basket of assets, usually a mix of stocks and bonds, which have been selected by teams of expert investors. But there are important differences between ETFs and mutual funds.
For starters, during normal US exchange trading hours, you can buy any ETF at the price it’s trading at, just like stocks. But with mutual funds, you have to wait until the markets close to buy or sell them since that’s when their net asset value, a measure that represents the commutative value of all of the fund’s assets, is calculated.
Here are some other key differences.
Consider the following hypothetical example:
There is a supermarket delivery service that offers customers two different weekly subscription options. Under the first option, your weekly order will be based on what the typical American household buys, which rarely changes over time. You cannot make substitutions or remove goods that you do not want. Total cost: $90 per week. And there is no minimum weekly subscription.
Under the second option, you can select a category that best suits your dietary needs. So if you’re vegan, you don’t have to worry about getting stuck with chicken breast. And as new products are introduced or certain items go on sale, the person overseeing the shopping lists will make adjustments. Total cost: $175 per week, and you must commit to at least an eight-week subscription.
The first option, in a very basic sense, is like an ETF. ETFs are typically constructed based on what’s included in a major index like the S&P 500 or a sub-index like the S&P 500 Consumer Staples. Because they follow the indices, the composition of ETFs generally only changes when the indices do, which is not often the case.
On average, index ETF fees reach 0.18% of your investment per year, according to a 2021 report by the Investment Company Institute (ICI), an investment industry association. So if you invest $1,000, you will pay $18 in fees.
That’s far less than the average 0.50% fee to invest in a stock mutual fund. In this case, if you invest $1,000, you will pay $50 in fees. Mutual funds, if you haven’t already guessed, are similar in a fundamental sense to the second option in the purchase example.
In either case, you are required to pay the fee, regardless of the performance of the fund or ETF.
So what justifies higher mutual fund fees?
Customer service level
Mutual funds tend to have higher fees than ETFs because they are often actively managed by a fund manager. This means that a team of investment experts closely monitors fund performance and trades securities based on what they believe will generate the best return for investors.
In addition to annual fees, many actively managed mutual funds require investors to make a minimum investment. For example, Vanguard has a minimum requirement of $3,000.
There are many exceptions as there are a wide variety of mutual funds. Index funds, a type of mutual fund that tracks a major stock market index, do not have fund managers who actively make investment decisions. As a result, index fund fees are even lower than ETF fees, 0.06% on average, according to ICI.
Which has better yields?
Take a look at the five-year performance of the oldest and one of the most popular ETFs, the SPDR S&P 500 ETF Trust, trading under the symbol SPY. As you can see below, it had almost identical returns against the S&P 500.
The reason it doesn’t perform the same as the S&P 500 is the result of slightly different sector allocations. For example, 26.93% of the SPY is made up of information technology assets, compared to 26.92% for the S&P 500. The expense ratio for the SPY is 0.0945%.
Now take a look at one of the most popular actively managed mutual funds, American Funds Washington Mutual Investors Fund Class 529-A, trading under AWSHX. Even with its 0.56% expense ratio, it has still underperformed the S&P 500 and SPY ETF over the past five years. But over the past year, he’s outdone both.
As you can see from the chart, this fund has a very different asset allocation from SPY.
SPY’s returns versus AWSHX are not indicative of the performance of all ETFs and mutual funds, as their asset allocation varies.
How to Choose What’s Right for You
The decision mostly comes down to cost and control.
ETFs generally charge lower fees and have lower minimum investments than mutual funds. Also, because of the way mutual funds are structured, they tend to incur higher taxes than ETFs while you own them.
With mutual funds, you lose some control over when you can buy or sell them and at what price. But you have the benefit of having a team of experts to make some of those decisions.
Elisabeth Buchwald is personal finance and markets correspondent for USA TODAY. You can FFollow her on Twitter @BuchElisabeth and sign up for our Daily Money newsletter here
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