Mutual funds and ETFs can both offer numerous benefits for your portfolio, including instant diversification at a low cost. But they have some key differences, in particular, how expensive the funds are. Overall, ETFs hold an edge because they tend to use passive investing more often and have some tax advantages.

Here is an overview of what differentiates a mutual fund from an ETF;

ETFs are a newer way of allowing investors to own a share in a larger portfolio. ETFs tend to be passively managed, meaning their holdings track a preset index of securities rather than having a portfolio manager picking them. They generally charge low expenses and have no sales commissions. ETFs usually do not have a minimum initial purchase requirement, though some brokers may not allow you to buy fractional shares of them. ETFs are traded during the day like a stock and their price can fluctuate around their net asset value.

Mutual funds are an older way of allowing a group of investors to own a share in a larger portfolio. Mutual funds tend to be actively managed, so they’re trying to beat their benchmark, and may charge higher expenses than ETFs, including the possibility of sales commissions. Mutual funds typically have minimum initial purchase requirements, and they can be purchased only after the market is closed, when their net asset value (NAV) is calculated and set.

The main difference between ETFs vs mutual funds is that mutual funds are actively managed, whereas ETFs are passively managed. While they have a lot in common, like consisting of a mix of different assets, there are more differences, too. Mutual funds allow for buying or selling assets within the fund to help investors make a profit, despite shifting markets. ETFs can be bought and sold in a similar way to stocks and tend to track a specific market index.

How they are managed:

• ETFs are passively managed funds that track a market index and make profits based on the tracked index performance.
• Mutual funds are run by an active fund manager, who usually has a team of analysts who attempt to beat the market.

Expense ratio:

• Passively managed funds are comparatively inexpensive, and some offer expense ratios** as low as 0.05%.
• The average annual expense ratio of actively managed funds is around 0.67%. Expense ratios can differ, based on the type of mutual fund you invest in.

Trading them:

• ETFs are traded throughout the day, just like stocks, where the price depends on the supply and demand. However, an ETF’s share price can be tied to the net asset value (NAV) during the creation and redemption process.
• Mutual funds provide their NAVs at the end of each trading day.

Minimum investment:

• ETFs are purchased based on the share price in the exchange market
• The majority of mutual funds have a minimum investment, although this could be low.

Redeeming Your Investment

To understand how investments are redeemed, you first need to know the difference between the ‘primary market’ and ‘secondary market’. Put simply, the primary market is where securities like stock and shares are created. The secondary market is where those securities are traded by investors and is commonly known as the Stock Exchange.

If an investor wants to redeem their investment, they usually return the shares to the fund manager who then sells the underlying assets and gives the money to the investor (the primary market). This applies regardless of whether the product is an ETF or a mutual fund. If the fund’s assets increase in value, the NAV also increases. Investors can buy and sell at NAV, potentially realising capital gains / losses every day.

ETFs are also traded on the stock exchange (secondary market), meaning they have two prices: the NAV and the stock market price. These two prices are closely linked through the redemption and creation process. If an investor wants to sell ETF shares, they’ll need to notify their broker who will decide whether to trade on the primary or secondary market (assuming this broker is also an authorised participant).

Verdict

For many different purposes, an ETF is a better option for investors, because it offers some tax advantages, low commissions and easy tradability. But in other specific circumstances, notably for stock index funds, mutual funds can actually be cheaper than ETFs, and if they’re held in a tax-advantaged account, their tax implications are irrelevant anyway. Either way, you need to know what your funds are invested in and how they help you achieve your financial goals.