Mutual funds and exchange-traded funds (ETFs) are two popular choices among long term investors for providing investment diversification, professionally managed portfolios by experienced money managers and potential high returns. Although they appear to be similar ranging at the surface, mutual funds and ETFs are actually different creatures built for very specific types of investors with particular investment goals. Then which is superior as an investment for the long term?
Throughout this comprehensive guide, we are going to compare and contrast mutual funds vs ETFs, covering each for the issues that matter most when choosing between them as options for your long-term investing strategy.
What Are Mutual Funds?
A mutual fund pools money from an array of investors to purchase a diverse portfolio of stocks, bonds or other securities. Actively-managed — These funds are overseen by professional portfolio managers who typically try to beat a particular benchmark or index.
Mutual funds are typically classified into different categories based on their investment objectives, such as:
- Equity Funds: Primarily invest in stocks.
- Bond Funds: Focus on fixed-income securities like bonds.
- Balanced Funds: A mix of stocks and bonds for more stable returns.
- Money Market Funds: Invest in short-term, low-risk securities.
The strength of mutual funds has always been their diversification — even for small investors. This differs from buying individual stocks or bonds, as investors technically own part of the fund and all the securities in it.
What Are ETFs?
While ETFs (Exchange-Traded Funds) are another form of pooled investment, they have a number of differences from mutual funds. Most ETFs mirror an index (such as the S&P 500 or NASDAQ), they are passively managed so their performance reflects the actual changes in holdings without trying to beat it. It should be mentioned, however, that there are also actively managed ETFs – just not nearly as many.
ETFs are traded in a different manner than mutual funds. Similar to individual stocks, ETFs are traded on stock exchanges during regular trading hours. This provides you with more flexibility and control over when you buy or sell.
Key Differences Between Mutual Funds and ETFs
To understand which investment vehicle might be better for long-term investing, it’s important to compare mutual funds and ETFs across several factors:
1.Management Style: Active vs. Passive
- Mutual Funds: Most mutual funds make use of active management techniques. These managers select individual stocks or bonds to purchase and sell, with the goal of outperforming a benchmark index. That means that the ETF is actively managed, which creates a higher-return potential in comparison with similar target-date funds. But it also results in two implications: Higher fees and Potential Underperformance of peers
- ETFs: ETF Market makers are familiar with the ins and out of ETF structures which is nearly always passively managed, seeking to replicate the performance of a particular index. Management fees are also usually lower since there is no ongoing decision process. Although passive management leads to a steadier performance, it also blocks opportunities for you to beat the market.
Which is better?
Passive Management style (ETF), which is ideal for long-term investor due to its lower cost and consistent performance. Alternatively, if you have confidence in a good fund manager’s capacity to beat the market (i.e. outperform), then perhaps actively managed mutual funds should attract your attention.
2. Fees and Expense Ratios
- Mutual Fund: A mutual is only trades one time a day after close of Market hours. In other words, you can only purchase or sell mutual fund shares at their NAV (net asset value), an end-of-day calculation.
- ETFs: ETF trade on stock exchanges, just like individual stocks, and can be bought or sold throughout the trading day. This lets you buy or sell shares at prevailing-market prices whenever the market is open, something that confers added flexibility. ETFs can also be traded with advanced trading strategies such as stop-loss orders or if you are really a professional, limit orders.
Which is better?
ETFs generally win the fee battle. The goal is to have the least amount of your investment working towards paying for fees long-term growth.
3. Liquidity and Trading Flexibility
- Mutual Funds: Mutual funds are traded only once per day after the market closes. This means you can only buy or sell mutual fund shares at the fund’s net asset value (NAV), calculated at the end of the trading day.
- ETFs: ETFs are traded throughout the day on stock exchanges, just like individual stocks. This allows you to buy or sell shares at market prices whenever the market is open, providing more flexibility. You can also use advanced trading strategies with ETFs, such as stop-loss orders or limit orders.
Which is better?
ETFs provide the benefit of having greater liquidity and accessibility in trading: they are good for investors who wish to control when and how they buy/sell their investments. But for long-term investors who are not interested in daily trading, the funds once-a-day trading may be a non-issue.
4. Minimum Investment Requirements
- Mutual Funds: Many mutual funds have minimum investment requirements, which can range from a few hundred to several thousand dollars. This can make mutual funds less accessible to new investors who are just starting out.
- ETFs: ETFs typically don’t have a minimum investment requirement beyond the cost of a single share, which can be as low as a few dollars. This makes ETFs more accessible to investors with limited capital.
Which is better?
ETFs tend to be more accessible for investors with smaller amounts of money. With mutual funds, the minimum investment requirements can be a barrier to entry for some investors.
5. Tax Efficiency
- Mutual Funds: Unlike ETFs, mutual funds are less tax-efficient because of the frequent buying and selling that portfolio manager does; it leads to higher capital gains distributions. When a mutual fund sells securities in its portfolio the tax gain is passed of virtue, and even an investor who never sold his own shares has to pay taxes on pass-thru gains
- ETFs: These are typically more tax-efficient than mutual funds, as they are able to employ an “in-kind” redemption process that can help reduce capital gains distributions passed onto the shareholder. This can be a big advantage for long-term investors who want to sidestep annual tax bills.
Which is better?
ETFs are generally more tax-efficient, which can help long-term investors keep more of their gains over time. This is especially important if you’re investing in a taxable account rather than a tax-advantaged retirement account.
6. Dividend Reinvestment
- Mutual Funds: Most mutual funds provide options for automatic reinvestment of dividends which means the most painless way to do this is recurring cash would just be used to purchase more shares in kind and there are no charges.
- ETFs: Dividend reinvestment may be available for some ETFs as well, although it is generally more rare and will depend on your broker platform. This might force you to plow dividends back which may be costly or slow way of reinvestment.
Which is better?
If automatic dividend reinvestment is important to you, mutual funds may be more convenient. However, many brokerages offer dividend reinvestment plans (DRIPs) for ETFs, so this is less of a deciding factor for most investors.
Which is Better for Long-Term Investing?
Choosing between mutual funds and ETFs for long-term investing ultimately depends on your individual preferences, financial goals, and investment style. Here’s a breakdown of which might be better for different types of long-term investors:
- ETFs Are Better If:
- You want lower fees and expenses.
- You prefer passive, index-based investing.
- You value trading flexibility and liquidity.
- You’re investing in a taxable account and want to maximize tax efficiency.
- You’re starting with a small amount of money and need low minimum investment requirements.
- Mutual Funds Are Better If:
- You believe in the potential of active management and are willing to pay higher fees for the possibility of outperformance.
- You want a more hands-off approach with automatic dividend reinvestment.
- You’re investing in a retirement account, where tax efficiency may be less of a concern.
- You’re comfortable with the one-time-per-day trading model and don’t need intra-day liquidity.
Combining Both for a Balanced Long-Term Strategy
Some say that the full-bodied experience for most long-term investors will be to sip from both mutual funds and ETFs. You could, for example, allocate toward actively managed mutual funds where you believe a manager’s skill in certain areas can provide an incremental benefit… other assets classes are — use low cost ETFs with exposure to the broader market.
To succeed in the long-term investment world itself, you have to play with your own rules or vehicles that scales along with it (still reflect on what instruments above) so be careful too. Both mutual funds and exchange traded funds offer advantages for long term investors, while learning these differences will allow you to make informed decisions that put your wife on the path toward financial independence.
Final Thoughts
Regardless of whether you use mutual funds, ETFs or some combination there of the biggest factor in long-term investing is a play on consistency. So long as you are contributing regularly to a diversified portfolio and working towards your financial objectives, compounding along with the growth of markets will be on your side over time. All these investment vehicles have their own merits and demerits, but with some careful planning you can think of devising a strategy which would enhance your success ratio over the long run.