ETF vs Mutual Fund - What Is the Difference?
When it comes to the world of trading and investing, market participants are faced with a sometimes overwhelming choice of financial instruments from which to choose. Exchange-Traded Funds (ETFs) and mutual funds are two such instruments available to investors.
To the casual observer, there may not appear to be a considerable amount of difference between these two types of fund. However, there are key differences one should be aware of before deciding to invest their money in either. In this article, we will explain the differences between an ETF vs mutual fund. We will look at both in detail, their advantages and disadvantages and which might be the best option for you.
What Is an ETF?
An ETF is a type of security which is designed to passively track an underlying index, economy, sector or any other asset. ETFs achieve this by using investor money to acquire a basket of securities, such as stocks and bonds.
Being passively managed means that, unlike an actively managed fund, which attempts to outperform the market, an ETF is merely seeking to mirror its underlying market.
The main characteristic of an ETF which distinguishes it from other funds is that they are traded on a stock exchange just like a company’s shares. This means that an investor can buy or sell ETF shares throughout the trading day, provided there is a willing counterparty.
This quality of being bought and sold on an exchange means that the market price is determined by current levels supply and demand and is, therefore, fluctuating throughout the trading day.
However, ETF providers want the current market value of the ETF shares to accurately reflect the Net Asset Value (NAV) of the fund’s portfolio at all times. In order to do this, sophisticated computer programming is employed which creates and redeems ETF shares in order to influence the current price.
For example, if the price is too low, ETF shares will be redeemed, decreasing supply and, therefore, increasing price. On the other hand, if the price is too low, the computer program will create more ETF shares, increasing supply and forcing the market price down.
Types of ETF
As mentioned above, an ETF can be created to track any financial asset or group of assets. Below we will list some of the most popular types of ETF as well as an example of each:
- Index ETFs - seek to replicate the performance of a specific market index, such as the FTSE100 or the S&P 500
- Industry ETFs - track the performance of a specific industry or sector
- Currency ETFs - attempt to track the performance of a currency or a basket of currencies
- Bond ETFs - seek to mirror the performance of a bond market
- Commodity ETFs - track the performance of a commodity or group of commodities
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What Is a Mutual Fund?
Like ETFs, mutual funds use a pool of investor money in order to acquire a portfolio of securities. Mutual funds can be passively managed to track an underlying market and, indeed, these types of “tracker” funds have increased significantly in popularity in recent years, as investors realise more and more that it is difficult for a fund to consistently outperform the market.
However, traditionally mutual funds are mostly actively managed, meaning that the managers who run the fund select their portfolio with the aim of attempting to outperform the market. This quality of being actively managed greatly increases the amount of work taken to manage the fund which, naturally, translates into higher fees for investors when compared with a passively managed portfolio.
When entering into a mutual fund, one purchases their shares, or units, from the company who manages the fund. This can be done either directly, or through a third party brokerage firm. Unlike ETFs, the price of a mutual fund is set only once a day, at the close of the market, when the fund’s NAV is established by dividing the net value of the fund’s holdings by the number of units outstanding.
Investors wishing to buy shares in the fund will buy them at this price and the same is true for those wishing to sell their shares - which will be absorbed back into the fund.
Types of Mutual Funds
There are many different types of mutual funds, designed to to suit different investors based on their goals and appetite for risk, below we will highlight some of the most popular:
- Equity Funds
- As the name implies, these are funds which focus on acquiring company shares. Equity funds make up the majority of mutual funds and can be further differentiated by the types of stocks which they acquire. For example, some funds will focus only on companies with large market capitalisation.
- Fixed Income Funds
- Again, as implied by the name, fixed income funds purchase debt instruments, such as government and corporate bonds, which provide a fixed income. An actively managed fixed income fund will target undervalued bonds to sell for a profit.
- Money Market Funds
- These funds invest in short-term, low risk debt instruments, such as government bonds and treasury bills.
- Balanced Funds
- These funds invest in a mixture of the different asset classes, increasing their exposure to different markets and thereby seeking a balance between risk and reward. Aggressive funds will hold more equities than debt instruments, whilst conservative funds will hold more debt instruments and fewer equities.
ETF vs Mutual Fund: Which Is Better?
Now you should be more familiar with ETFs and mutual funds, but when it comes to choosing between an ETF vs mutual fund, which option is best?
Unfortunately, there is no definitive answer to this question. Each choice comes with its own list of advantages and disadvantages and, at the end of the day, the best option depends entirely on the person asking the question.
We have already provided an overview of both investments, now we will have a closer look at some of the key similarities and differences to help decide which is better between an ETF vs mutual fund.
Which Carries More Risk?
All investments carry the risk of losing your money and both ETFs and mutual funds are no exception.
Both ETFs and mutual funds offer investors instant diversification over a range of different assets, with funds holding hundreds or sometimes thousands of different individual securities.
Diversification is viewed as a key part of good risk management, as it prevents investors from putting “all their eggs in one basket”. In this sense, investments in ETFs and mutual funds can both be seen as having less risk than investing in the shares of one or two companies.
When it comes to picking between an actively managed mutual fund and a passively managed ETF, the ETF could be considered to have less risk. This is due to the fact that a fund which is actively managed picks its securities in an attempt to outperform the market. If a fund manager picks the wrong security it could be detrimental to the fund.
With mutual funds, the level of risk is also dependent on the type of fund in question. An equity fund is seen as having a much higher level of risk than fixed income or money market funds.
Both ETFs and mutual funds will charge a management fee. However, an actively managed mutual fund will charge higher management fees than an ETF (or a mutual fund which is passively managed). This is due to the need to employ a fund manager and a supporting team to make investment decisions.
Mutual funds are designed to be a long term investment and, therefore, some mutual funds will also incur a large penalty if an investor sells their shares within a specified time period.
It must also be noted that as ETFs are purchased on a stock exchange, via a brokerage, they are subject to broker’s commission. The amount of commission varies depending on the broker in question, with some brokers not charging any commission at all.
ETFs are also subject to the spread. The spread is the difference between the buying and selling price of an asset and is one of the main sources of income for a broker. The price to buy tends to be higher than the price to sell, meaning that if you were to buy and then sell an ETF straight away, you would lose money.
The size of the spread depends largely on how popular the ETF is. The more it is traded, the lower the spread will tend to be and vice versa.
Liquidity can be defined as the measure of the ease with which a financial position can be converted into cash.
An ETFs liquidity is dependent on finding a counterparty in the market wishing to undertake the opposite transaction to you. Therefore, popular ETFs are likely to have high liquidity, meaning that there should not be an issue buying or selling a position.
However, unpopular ETFs may suffer from illiquidity, due to there being less interest. This means that you may have difficulty finding a counterparty for your transaction and could become stuck with shares in an ETF for longer than you had wanted to.
With mutual funds, however, shares are exchanged between yourself and the fund, meaning that you do not need to locate a counterparty to make a transaction. If you want to enter a fund, the fund will create new shares for you to purchase. If you want to exit the fund, you notify the fund as such.
Mutual fund managers tend to hold a certain percentage of total investments as cash, in order to be able to liquidate an investors position if needed. This approach can be problematic if too many investors want to leave the fund at the same time - as the fund will be required to unwind some of their investment positions to free up cash.
When it comes to tax efficiency between an ETF vs mutual fund - ETFs have the advantage. Although both are in fact fairly tax efficient vehicles, in general, ETFs have the edge because there are less transactions taking place within the fund.
Every time a fund sells a security from its portfolio, any profit is subject to capital gains tax, which is borne by all the members of the fund. In addition, when funds or ETFs buy shares they have to pay 0.5% stamp duty on the value of the shares.
Because an actively managed mutual fund tends to be entering and exiting positions in the market more frequently than an ETF, there tends to be more of these two taxes incurred.
How to Buy ETFs With Admirals
With an Invest.MT5 account from Admirals you can invest in both stocks and ETFs from 15 of the world’s largest stock exchanges!
In order to open an account, follow these steps:
1. Register with Admirals
2. Log in to your Trader’s Room account
3. Click on the ‘Open Live Account’ button
4. Fill in your the requested information, which will include your contact details, tax ID and passport number
5. Upload the requested documentation
Once you have completed your application, it will be reviewed by Admirals who will contact you with the result by email. If your application is successful you will receive your account details by email.
In order to start investing in ETFs with Admirals, you will need to do the following:
1. Download the MetaTrader 5 trading platform
2. Open the trading platform and press Control + U to bring up the Symbols window, shown below. Locate the ETF you wish to purchase, then select Show Symbol’ and then ‘OK’
Depicted: Admirals MetaTrader 5 - Symbols
3. Head to the Market Watch tab and find the trading symbol which you have just added, right click it and select ‘Chart Window’
Depicted: Admirals MetaTrader 5 - Vanguard FTSE 100 UCITS ETF Daily Chart. Date Range: 15 November 2018 - 31 March 2021. Date Captured: 31 March 2021. Past performance is not necessarily an indication of future performance.
4. Right click anywhere on the chart, select ‘Trading’ and ‘New Order’. You will be presented with the box shown below, where you can select the desired volume of your purchase as well as set a stop loss and a take profit
Depicted: Admirals MetaTrader 5 - New Order
When it comes to choosing between an ETF vs mutual fund, the decision depends on the person in question. Hopefully, after reading this article, you should understand more clearly why somebody might choose an ETF over a mutual fund and vice versa.
If you are looking for a more hands on trading experience, with potentially lower fees and greater tax efficiency - then an ETF is likely to be a good choice.
Admirals is a multi-award winning, globally regulated Forex and CFD broker, offering trading on over 8,000 financial instruments via the world's most popular trading platforms: MetaTrader 4 and MetaTrader 5. Start trading today!
This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.