What are mutual funds and ETF? How are they similar and what are the differences? Which on should you buy?
Mutual Funds and Exchange Traded Funds, or ETFs, are some of the easiest ways to invest your money in a way that meets your investment goals in terms of risk while providing diversity in your portfolio. Mutual Funds and ETFs are similar in that both are financial instruments that allow you to invest in assets like stocks, bonds, and money market instruments. When you buy a unit in a Mutual Fund or a share in an ETF, your money is pooled together with the money from a bunch of other investors that bought units or shares. The professional money managers working for that Mutual Fund or ETF will invest the pool of money and charge you a fee for their services. These professional money managers will buy assets to produce capital gains and/or income for the investors. The types and mix of assets that the money managers buys with your money is determined by what is called the prospectus. In a nutshell, a prospectus is a document that outlines how they are going to invest your money. This document is important because it will tell you their strategy, so you had better make sure that it is designed to do what you expect. Some are designed to pay dividends and other are designed for capital gains. Others are designed around a specific theme like investing green energy or cloud computing. A really popular option recently are what are called Index Mutual Funds and Index ETFs. These will buy the same mix of stocks as the major stock indexes, or what is generally referred to as the “stock market”. Index funds have been a great way to keep your money growing at a similar rate to the stock market. Warren Buffett is one of the greatest investors ever made a very famous million dollar bet with a hedge fund, by the name of Protégé Partners LLC, that they could not beat an index fund tied to the S&P 500 over a 10 year period. At the end of that 10 year period the index fund won. The fund Warren Buffett selected was the Vanguard 500 Index Fund Admiral Shares (VFIAX) (https://investor.vanguard.com/mutual-funds/profile/VFIAX). Allot of it was to do the huge fees they charge their clients which was 2% plus 20% of the profit.
What are the differences between a Mutual Fund and an ETF.
Mutual Funds have been around for quite some time and is still widely used. The share price of a mutual fund is known as its Net Asset Value or NAV. It is calculated by adding up the value of all the assets it holds and dividing that by the total number of outstand mutual fund shares. This value is calculated once a day at the end of the trading day. Every year the mutual fund will charge you anywhere a management fee that ranges from 1 to 3% which is called the expense ratio. While you own a mutual fund, if there are dividends they normally give you the option of taking the money or use it to buy more shares. Mutual funds normally also charge you fees to buy and/or sell your mutual fund shares which are called front-end or back-end loads. Front-end means they charge you at the time of purchase and back-end are charged when you sell. Some also charge you a fee if you withdraw your money early. There are also a few that are called no-load so they do not have sales charges. Additionally, mutual funds normally have a minimum amount that you need to buy. When you want to sell your mutual funds it can take a couple of days. Then you buy or sell your mutual funds, it is the fund itself that is selling and buying them from you so often there may be tax implications.
ETFs or Exchange Traded Funds normally charge a much smaller management fee which is usually a fraction of a percent. Right there you are typically doing better by about 2% per year for potentially the same group of assets. 2% may not sound like a big difference but it is. If you invest $10,000 and get 2% compounded interest compounded annually after 20 years you will have almost $14,860. You made almost $4900 from just 2% compounded annually. That is a nice chunk of change.
The next difference is that ETFs are traded on the stock exchange just like regular stocks. Like a stock, the value of the ETF changes throughout the day. Like most regular stocks, an ETF can be bought or sold within a couple of minutes of submitting the order. Being able to buy or sell ETFs quickly means that they are very liquid. Your broker will charge a small fee to execute the buy or sell order. Some brokers do not charge a fee for trading like Alley Invest, E*Trade or WealthSimple. The high liquidity means that sometimes the Net Asset Value will not match what the price of the ETF share but authorized participants will normally bring those back in alignment.
I personally prefer ETFs for the following reasons:
- ETFs are more tax efficient
- Low and simple fees to buy and sell them
- Very liquid so you can buy and sell them quickly
- My favourite reason is the lower management fees or expense ratios. This means more money is going into your pocket.