ETFs and mutual funds are both popular investment vehicles that investors use to add various asset classes to their portfolios. Depending on your return goals and risk tolerance, you can choose either or both.
Let’s explore what ETFs and mutual funds are and how they work for different asset classes.
What are ETFs?
ETFs or exchange-traded funds are collections of hundreds (and even thousands) of stocks or bonds combined into a single fund managed by an expert or team of experts in an investment firm. This single fund is publicly traded on major global stock exchanges like the NYSE and Nasdaq.
ETFs combine the flexibility of stocks with the portfolio-diversity benefits of mutual funds. They can give you a wide range of asset classes at affordable prices.
ETFs typically track a particular index, sector, commodity, or other asset class. They can be structured to follow anything from the price of an individual item to a large and diverse collection of securities. ETFs can even track specific investment strategies.
Types of ETFs
ETFs are present in almost every investment niche. This means investors have plenty of options when it comes to choosing an ETF, but it also means that you can get a little overwhelmed with all the choices available. Here are some of the most popular ETFs to invest in for 2023:
These ETFs invest in a basket or collection of company stocks giving investors access to hundreds or thousands of stocks in a single investment. Examples: SPDR S&P 500, iShares Russell 2000.
Fixed-income or Bond ETFs reduce the volatility of your portfolio by investing in entire bond markets. An example is iShares Core U.S. Aggregate Bond ETF (AGG).
These are ETFs that invest in stocks of companies based outside the US. An example is Vanguard FTSE Developed Markets ETF.
These are ETFs that invest in different types of real estate ranging from niche rental units to broad property types. Example: Vanguard Real Estate ETF (VNQ).
Currency ETFs insulate your portfolio against the slow depreciation of the US dollar by investing in specific or broader international currencies. Example: Invesco CurrencyShares® Euro Currency Trust (FXE).
These ETFs select and weigh stocks based on each company’s market capitalization size—the total value of its shares.
Benefits and Risks of ETFs
Every investment carries a degree of risk with it. That being said, ETFs are generally considered low-risk investments because they hold a collection of stocks or assets and come with a relatively low investment cost to investors.
- Diversification: ETFs can help you diversify your portfolio across asset classes, sectors and geographies that otherwise could be difficult to access. Their low entry cost makes them more attractive to new investors than individual stock investments.
- Good Returns: As the underlying value of their assets changes, so will the value of the ETF stock. This means investors can earn returns through price growth or distributions of the assets under their ETFs.
- Tax Efficient: They can also be tax-efficient than mutual funds because most ETFs are passively managed and carry fewer capital gains than actively managed mutual funds.
- Frequent Price Changes: ETFs go through intra-day price changes. The prices of an ETF could change in a couple of hours, meaning longer-term investors with a time horizon of 10 to 15 years may need help to benefit from investing in an ETF.
- Costs: The costs of ETFs compared to investing individual stocks are higher. This can be discouraging for new investors that want to get the most out of their investments.
- Low-Yields: While there are dividend-paying ETFs, their yields may be lower than owning a high-yielding stock or group of stocks. The risks with ETFs is usually lower, but if you can take on the dangers of high-yielding stocks, the dividends on stocks will be a fair bit higher than an ETF.
What Are Mutual Funds?
Mutual funds are professionally managed portfolios of stocks, bonds and/or other income vehicles that stick to a specific investment strategy or asset class. Mutual fund managers allocate the funds’ assets and attempt to create capital gains or income for the fund’s investors.
Money invested in a mutual fund gets pooled and allocated to assets and investments made on the investor’s behalf by the fund managers. A single share in a mutual fund represents a portion of the fund’s holdings. Every mutual fund has a prospectus that helps structure and maintains its portfolio and objectives.
Shareholders each carry the gains or losses of the fund proportionally to their investment in the fund. Mutual funds usually invest in many securities, and each mutual fund has a fund manager legally obligated to work in the best interest of the funds’ shareholders.
Types of Mutual Funds
Many types of mutual funds are available to investors; below are the more popular options for both new and seasoned investors.
These are mutual funds that primarily invest in stocks or equity. Small-, mid-, and large-cap stock funds are named after the size of the companies they invest in. Aggressive growth, income-oriented, value, and others are named after their investment approach.
Bond funds focus on investing in assets that pay a set rate of returns, such as government bonds, corporate bonds, or other debt instruments. These funds are usually actively managed.
Index funds invest in stocks that correspond with major stock indexes like the S&P 500 or the Dow Jones Industrial Average. These funds require less research to manage, so they come with low fees for the investor. Index funds are great options for cost-conscious investors.
These mutual funds deliver results by investing across various asset classes. They also get adjusted over time to meet the shareholders' needs better.
Benefits and Risks of Mutual Funds
- Managed by Experts: Mutual funds are managed by professionals with a legal obligation to run the fund according to the shareholder’s best interests. These managers usually have years of experience and the skills needed to navigate the best investment options for the fund over a long period of time.
- Diversification: Your money isn’t invested into a single asset with a mutual fund; it’s pooled and spread across several securities. This gives your portfolio a high level of diversification, which protects you against risk and volatility.
- Liquidity: Mutual funds also increase the liquidity of your portfolio, depending on the type of fund you invest in. You can quickly and easily convert your mutual fund asset into cash.
- High Fees: High fees mean that the returns on your investments may be smaller than you expect. Always look for mutual funds that have low or no sales charges. Yes, the funds are run by professionals, but this can make it quite costly for the investor.
- Tax Inefficiency: Tax inefficiency is another disadvantage of mutual funds. Due to the turnover, redemptions, gains, and losses in security holdings throughout the year, investors typically receive distributions from the fund that are an uncontrollable tax event.
- Execution: Investors looking for faster execution times because of short investment horizons, day trading, or timing in the market usually avoid mutual funds since they offer a weak execution strategy.
ETFs Vs. Mutual Funds
Mutual funds and ETFs are very similar in their function and what they can offer investors. They’re separated by a few key differences, which can make the difference when deciding which one to invest in.
If you prefer lower investment minimums, ETFs may be your better choice. You can buy into an ETF for the price of one share, which may be as little as $50.00.
ETFs also offer you more ‘hands-on’ control over the price of your trades. They provide real-time pricing and better order types, giving you more control over your price. Mutual funds only offer the same price as everyone who bought in and sold on the day.
Mutual funds offer you the benefit of repeating specific transactions automatically, something that isn’t available with ETFs. And if you’re looking to invest in an index fund, both ETFs and mutual funds are great options.
Depending on your goals and initial investment preferences, you may invest in mutual funds, ETFs, or both. Each option offers a similar investment opportunity, providing a great amount of diversification and risk reduction to your portfolio.