On the surface, mutual funds and exchange-traded funds (ETFs) look alike. They both pool investments, like stocks or bonds, charge fees and offer reports, such as financial statements, quarterly, semi-annual or annual statements, but that’s generally where the similarities end.
Here are four important differences between mutual funds and ETFs:
1. Active vs. Passive
One of the main differences between mutual funds and ETFs boils down to how investmentInvestment An item of value you buy to get income or to grow in value.+ read full definition decisions are made. Most mutual funds are typically managed by a portfolio managerPortfolio manager An investment professional who manages your investment portfolio. For example, they buy, sell and monitor investments that fit their clients’ goals and tolerance for risk.+ read full definition who takes a hands-on approach to decide which investments the fund holds and typically follow a set of rules around the types of investments they buy and sell to achieve their investment objectives. This means they have the freedom to respond to changes in the market in an attempt to limit losses and pursue opportunities that could allow them to outperform their benchmarkBenchmark A yardstick that you can use to measure the performance of an investment. Example: a stock market index may be a benchmark you can use to compare how well your own stocks are doing.+ read full definition.
Mutual funds and ETFs have similar fees and expenses, but there is often a disparity between how much the fees and expenses differ. Typically, the management expense ratio (consisting of the management feeManagement fee A charge that you pay for having an investment professional manage an investment fund. The fee pays the managers for their time and skills. It may also cover things like communicating with investors and doing all the paperwork needed to run the fund.+ read full definition and other operating expenses) of ETFs tend to be lower than mutual funds. The average Canadian equity mutual fundEquity mutual fund A mutual fund that invests in a broad mix of stocks. In most cases, an equity fund won’t invest in any bonds.+ read full definition MER is about 2%, but it’s not uncommon for them to climb above 3%.
By comparison, the typical MER for equityEquity Two meanings: 1. The part of investment you have paid for in cash. Example: you may have equity in a home or a business. 2. Investments in the stock market. Example: equity mutual funds.+ read full definition-focused ETFs is about 0.54% and, apart from a few exceptions, they are almost all below 1%. While the difference between the MERs for a mutual fundMutual fund An investment that pools money from many people and invests it in a mix of investments such as stocks and bonds. A professional manager chooses investments that match the fund’s goals for risk and return. You can redeem your fund units at any time.+ read full definition and ETF may seem small, it can add up over time. Consider the impact on a $1,000 annual investment earning 5% over 15 years. A 2% MER for a mutual fund costs you $3,501 in fees over that time, whereas an MER of 0.54% would cost just $1,011. After factoring in returns, it would mean the difference between owning an investment worth $19,157 or $21,646 (See Fee Calculator)
3. Buying and selling
Apart from cost, how you buy and sell ETFs and mutual funds is another notable difference. ETFs tradeTrade The process where one person or party buys an investment from another.+ read full definition like stocks on a stock exchangeStock exchange A market in which securities are bought and sold.+ read full definition, which means every fund can be traded during the hours the exchange is open for trading. Each ETF has a tickerTicker A record of the current or recent trading activity on an exchange.+ read full definition and the market priceMarket price The amount you must pay to buy one unit or one share of an investment. The market price can change from day to day or even minute to minute.+ read full definition on the exchange can fluctuate during a trading day.
Like a stockStock An investment that gives you part ownership or shares in a company. Often provides voting rights in some business decisions.+ read full definition, each ETF will have a “bid price” and an “ask price” on the exchange. A bid price is the highest a buyer is willing to pay for a security, whereas the ask price refers to the lowest amount a seller will accept for a security. The difference between the two is called the “bid-ask spreadBid-ask spread The gap between the price a buyer is willing to pay and the price a seller is willing to accept.+ read full definition” and it is a trading cost for investors. Finally, while the market price of an ETF is generally expected to track the underlying value of the portfolioPortfolio All the different investments that an individual or organization holds. May include stocks, bonds and mutual funds.+ read full definition held by the ETF, the ETF may trade above the underlying value (commonly referred to as trading at a “premium”) or below the underlying value (often referred to as trading at a “discountDiscount When something sells for less than its normal price.+ read full definition”).
4. Automatic contributions
Setting up an automatic contributionContribution Money that you put into a savings or investment plan.+ read full definition plan can be an effective way to grow your savings quickly. Investing smaller amounts at regular intervals is more manageable than investing in one lump sum. A mutual fund accountAccount An agreement you make with a financial institution to handle your money. You can set up an account for depositing and withdrawing, earning interest, borrowing, investing, etc.+ read full definition can regularly steer those new contributions into the mutual fund if you set up an automatic contribution plan to help you achieve your investment goals.
That’s not always the case for ETFs. Many discount brokerageDiscount brokerage A brokerage firm that charges lower fees to buy and sell investments, as opposed to a full-service brokerage. Does not provide investment advice.+ read full definition accounts don’t allow automatic ETF purchases, although some robo-advisors are now providing this service. If your account doesn’t permit automated purchases, it will be up to you to remember to investInvest To use money for the purpose of making more money by making an investment. Often involves risk.+ read full definition the funds periodically. Another downside of this approach is that you may also incur trading costs each time you do. While trading fees may be low, they can quickly add up when investing small amounts.