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  • Writer's pictureMark Fonville, CFP®

ETF vs Mutual Fund: What's the Difference?

Updated: Jan 7


ETF Vs Mutual Funds: What's the Difference?

For those seeking to plan for their retirement, understanding the difference between exchange-traded funds (ETFs) VS. mutual funds is crucial.


Both investment vehicles can offer access to a wide range of assets, providing you with ample diversification. Additionally, many ETFs and mutual funds will have different investment strategies. This allows you to cherry-pick the funds that most align with your financial goals.


Before you invest in any security, we recommend that you talk with an experienced financial advisor who can help tailor your investment plan for your situation.


For example, some funds focus on steady income while others focus on growth.


While ETFs and mutual funds are similar, there are a few key differences to be aware of.

ETFs, akin to stocks, trade on exchanges throughout the day. This allows for real-time trading and more flexibility. On the other hand, mutual funds trade at the day's close.


Understanding how an ETF differs from a mutual fund can help you make informed financial decisions for a successful retirement.



Why should I invest in ETFs or mutual funds?


Before jumping into the differences between the two, it’s important to note that both of these investment vehicles can help diversify your retirement portfolio.


While diversification does not guarantee against loss, it can help to spread risk and potentially enhance stability in your retirement portfolio.


This is particularly useful for those who are close to retirement, where preserving capital, providing liquidity, and generating consistent income are primary goals.

 

Next Steps: Understanding how to properly diversify your investment portfolio is complicated. This tool will connect you with a fiduciary financial advisor at Covenant Wealth Advisors with over 15 years of experience.


Here's how it works:


  • Answer these few easy questions, so we can understand your situation.

  • Schedule a call with a credentialed financial advisor who can help you on the path toward achieving your financial goals. It only takes a few minutes.

  • Get your free investment and retirement assessment.




 

With that said, let’s jump into the basics of ETFs and mutual funds so you can gain a better understanding of which is right for you.


What’s an ETF?


ETF

An Exchange-traded fund (ETF) is a type of pooled investment security that can hold assets such as stocks, bonds, or commodities. ETFs have a singular focus, like tracking a specific sector (i.e. utilities), index (i.e. S&P 500), or asset class (i.e. U.S. Small Cap Value). Additionally, they are traded traded on stock exchanges just like an individual stock.


Fund managers have built ETFs for a broad range of investors, from beginners to professional traders. They’re also popular among the retired crowd due to their diversification, flexibility, and cost efficiency. In other words, ETFs can be a valuable addition to your portfolio regardless of your age, net worth, or goals.


Here are some pros and cons to consider with ETFs:


Pros of investing in ETFs


  1. Diversification: ETFs often hold a wide range of securities. For example, the Vanguard 500 Index Fund ETF tracks all of the stocks in the S&P 500. This can provide instant exposure to a wide range of securities, helping to diversify your holdings and reduce the risk in your portfolio.

  2. Liquidity: You can buy or sell ETFs throughout the trading day at market prices. This offers liquidity, flexibility in trading, and allows you to access your cash at a moment’s notice.

  3. Low Costs: Many ETFs have lower expense ratios compared to actively managed mutual funds, making them cost-effective for investors. The average expense ratio for actively managed mutual funds is between 0.5% and 1.0%, compared to about 0.2% for passive index funds. If you still have a decade or so before you plan to retire then these lower fees can really add up.

  4. Transparency: Since ETFs are publicly traded, their assets and movements are publicly available. This allows investors to see exactly what assets they own at any given time.

  5. Tax Efficiency: ETFs are generally tax-efficient due to the "in-kind" creation and redemption process, which helps minimize capital gains distributions. This can be a major advantage for higher income investors to help reduce taxes over time.

 

Next Steps: Understanding how to properly diversify your investment portfolio is complicated. This tool will connect you with a fiduciary financial advisor at Covenant Wealth Advisors with over 15 years of experience.


Here's how it works:


  • Answer these few easy questions, so we can understand your situation.

  • Schedule a call with a credentialed financial advisor who can help you on the path toward achieving your financial goals. It only takes a few minutes.

  • Get your free retirement portfolio and retirement assessment.




 

Cons of investing in ETFs


  1. Diversification May Limit Substantial Upside Potential in the Short-Term: For the most part, ETFs passively track a wide range of assets which helps stabilize their price. This means that they offer a great way to track the return of an index or market over time. But, the potential downside is that they generally have limited potential for earning outsized returns in the short-term.

  2. Learning Curve: For beginners, understanding how ETFs work and navigating the variety of options available may require a learning curve. This is largely due to the number of different ETFs that are available.

  3. Premiums and Discounts: ETFs can trade at a premium or discount to their net asset value (NAV), impacting the cost of buying or selling shares. This opens the potential for buying ETFs that are trading above their NAV.

  4. Trading Costs: Because ETFs are traded like stocks, there is often a bid-ask spread, which is the difference between the highest price a buyer is willing to pay for an ETF and the lowest price a seller is willing to accept. Wider spreads can increase the cost of trading ETFs, especially for those that are not heavily traded.

  5. Setting Up Automatic Investments: ETFs don't allow for automatic investment or withdrawals.

  6. Risk of Market Impact: When there is little trading volume in a certain ETF and you buy or sell a big amount, it can really change the price of that ETF. This can be a downside, especially if it causes the price to move in a way that's not good for you as the investor.


What’s a Mutual Fund?


Mutual Funds

A mutual fund is an investment vehicle that pools money from multiple investors and provides a diversified portfolio of stocks, bonds, or other securities.


Imagine a big basket where a bunch of investors throw their money in together. This basket is managed by a professional who decides what to put in it, like stocks, bonds, or other assets.


The idea is that by pooling their money, investors can buy a bigger mix of investments than they could on their own, and this mix is handled by someone who knows the ropes of the stock market.


So instead of you trying to pick winners in the stock market all by yourself, you own a little slice of a big, varied pile of investments that the mutual fund picks out and looks after.


Below are the pros and cons to consider when investing in a mutual fund:


Pros of investing in a mutual fund:


  1. Professional Management: Mutual funds are managed by experienced professionals who invest based on research and analysis. This opens the possibility of outperforming the market due to savvy investments made by the fund manager.

  2. Diversification: By investing in a mutual fund, investors gain exposure to a diversified portfolio of assets. This spreads risk across various securities.

  3. Liquidity: You can buy or sell mutual funds at the end of the trading day at the Net Asset Value, providing liquidity to investors.

  4. Accessibility: Mutual funds allow investors to access a diversified portfolio with low investment amounts. This can make them suitable for those with limited capital.

  5. Automatic Reinvestment: Many mutual funds offer automatic reinvestment of dividends and capital gains, helping to compound returns over time.


Cons of investing in a mutual fund:


  1. Fees: Mutual funds often come with higher fees than index funds, including management fees and other expenses. Again, the average expense ratio for actively managed mutual funds is between 0.5% and 1.0%, compared to about 0.2% for passive index funds

  2. Lack of Control: Investors in mutual funds delegate decision-making to fund managers. This means that you have no control over the fund’s investment decisions.

  3. Tax Inefficiency: Mutual funds can distribute capital gains to investors on an annual or more frequent basis, leading to reduced after-tax returns.

  4. End-of-Day Trading: Unlike ETFs, mutual funds only trade at the end of the trading day at the NAV. Due to this, they may not be suitable for investors who prefer intraday short-term trading.

  5. Minimum Investment Requirements: Some mutual funds may have minimum investment requirements, limiting access for certain investors.


ETF vs Mutual Funds: Biggest Differences


In the wide investment landscape, understanding the nuances between mutual funds and ETFs can save you time and money in retirement. As two prominent players in the financial realm, these vehicles offer distinct tradeoffs. Grasping these differences can empower you to make better decisions when planning for retirement.


Here are some of the most notable differences between mutual funds and ETFs:


Trading and Liquidity:

  • Mutual Fund: Traded at the end of the trading day at the NAV.

  • ETF: Traded on exchanges throughout the day at market prices.

Management Style:

  • Mutual Fund: Actively or passively managed by professionals who make investment decisions.

  • ETF: Often passively managed (although this is changing), aiming to replicate the performance of a benchmark index.

Minimum Investment:

  • Mutual Fund: May have minimum investment requirements.

  • ETF: Typically has no minimum investment other than the cost of one share and any associated brokerage fees.

Fees:

  • Mutual Fund: Can have management fees and other expenses, which vary among funds.

  • ETF: Generally have lower expense ratios compared to actively managed mutual funds.

Tax Efficiency:

  • Mutual Fund: Can distribute capital gains to investors, potentially leading to tax implications.

  • ETF: Often more tax-efficient due to the "in-kind" creation and redemption process.



Which One Is Right for You?


Whether you choose to invest in mutual funds or ETFs, each carries its own set of advantages and drawbacks.


ETFs offer the advantage of more flexibility. You can buy and sell shares throughout the day at market prices which can be valuable if you want to react promptly to market changes. ETFs also generally (but not always) charge lower fees which, over the long run, can result in the potential for higher returns for your portfolio. On the other hand, mutual funds, with their professional management, create the opportunity to achieve outsized returns.


With that said, both ETFs and mutual funds can be a good investment decision for investors who are nearing retirement because of:


  • Diversification: Both vehicles allow you to quickly and easily diversify your portfolio and protect your capital.

  • Growth and income: Both vehicles are a good option to help build long-term wealth. Additionally, there are funds available that focus specifically on creating income which can help supplement income from pensions, social security, and other sources.

  • Simplify: Both ETFs and mutual funds can help you simply your retirement portfolio for easier management vs tracking a complex bucket of stocks.


Ultimately, the choice between ETFs and mutual funds hinges on your financial goals, risk tolerance, and investment preferences. Carefully considering these factors can help tailor your investment approach to meet the unique demands and goals of your retirement years.


Ready to take control of your retirement and investment planning? Jumpstart your financial security and help avoid major money mistakes by taking advantage of our free retirement assessment.


Don't miss out on this opportunity to make informed decisions about your financial well-being. Start planning today!

 

Mark Fonville, CFP
Mark Fonville, CFP

Author: Mark Fonville, CFP®


Mark is a fiduciary, fee-only financial advisor at Covenant Wealth Advisors specializing in helping individuals aged 50 plus plan, invest, and enjoy retirement without the stress of money.


Forbes nominated Mark as a Best-In-State Wealth Advisor* and he has been featured in the New York Times, Barron's, Forbes, and Kiplinger Magazine.


 

Disclosure: Covenant Wealth Advisors is a registered investment advisor with offices in Richmond and Williamsburg, VA. Registration of an investment advisor does not imply a certain level of skill or training. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. The views and opinions expressed in this content are as of the date of the posting, are subject to change based on market and other conditions. This content contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Please note that nothing in this content should be construed as an offer to sell or the solicitation of an offer to purchase an interest in any security or separate account. Nothing is intended to be, and you should not consider anything to be, investment, accounting, tax, or legal advice. If you would like accounting, tax, or legal advice, you should consult with your own accountants or attorneys regarding your individual circumstances and needs. No advice may be rendered by Covenant Wealth Advisors unless a client service agreement is in place. Hypothetical examples are fictitious and are only used to illustrate a specific point of view. Diversification does not guarantee against risk of loss. While this guide attempts to be as comprehensive as possible but no article can cover all aspects of retirement planning. Be sure to consult an advisor for comprehensive advice.


Registration of an investment advisor does not imply a certain level of skill or training.


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