Investing Basics: Mutual Funds vs ETFs

Never let investing intimidate you. Yes there can be a lot of technical jargon and odd terms, but the basics aren’t too hard to learn and understand. Especially now, with the power of the internet you have endless videos, blogs, social media and dedicated websites making it easier than ever to decipher it all. Below I share the basic differences between ETFs and mutual funds. Hopefully if you’re new to this world this will provide you with a minimum level of understanding about these two approaches to investing.

ETFs

An ETF (Exchange Traded Fund) is a basket of stocks an investor or trader can buy or sell like an individual stock. For example, if I wished to invest in hotels I could buy Hospitality Properties Trust (HPT). HPT is an ETF that pools a number of hotel stocks together including Marriot, Hyatt, Intercontinental Hotels, etc. Buying the ETF allows me to invest in the entire hospitality sector eliminating the need to buy each individual stock.

Mutual Funds

In principle mutual funds are not much different from an ETF, both are a pool of securities (stocks, bonds, etc.). For example, if I wanted to invest in insurance companies I could purchase Fidelity’s Select Insurance Mutual Fund (FSPCX). This mutual funds contains numerous insurance company stocks including Allstate, MetLife, Prudential, Aflac, Travelers, etc. No need to buy a dozen different insurance company stocks, I can just buy FSPCX.

Making a Purchase

You can buy and sell 1 share of 1 million shares of an ETF, but this is not so with a mutual fund. A mutual fund will have a minimum investment amount (e.g. $3000). If today’s share price of a mutual fund was $50, I would have to purchase at least 60 shares if the minimum investment amount was $3,000 ($3,000 / $50 = 60 shares). You can only buy or sell a mutual fund once in a day because it doesn’t trade like a stock. A mutual fund’s share price only changes from day to day (updated at the end of the day after the market closes).

An ETF is different, it trades like a stock. Its share price can change every second, minute and/or hour of the trading day. Thus you can choose to buy or sell it at any point during the trading day. You can buy 1 share or a million shares, there is no minimum. You can also choose to buy and/or sell an ETF once a day, 10 times in a day, 100 times in a day, etc., there is no limit to that either. These characteristics make it very different from a mutual fund.

Transaction Fees

ETFs are traded just like stocks which means they come with transactions fees. If your trading account charges you $5 to buy or sell a stock, the same price will apply when you buy and sell an ETF. Mutual fund transaction fees can a bit more complex and (sometimes) less transparent. For example a firm may charge a redemption fee on shares held for less than 30 days. This is to prevent people from trading in and out of the fund like its a stock. Mutual funds desire long term investors, not short term traders.

Another mutual fund transaction fee is a sales ‘load’ fee which are just commissions paid to salesmen. This can be charged either upfront at the time or purchase or at the backend when you sell the mutual fund. A load is a percentage of the amount your investment. So, if you invest $10,000 into a fund with a 5% upfront load you’re immediately giving away $500 to the broker and only investing $9,500! Alternatively if there was a 5% backend load and your $10,000 grew to $25,000 in 10 years you would only net $23,750, sacrificing $1,250 to a commission.┬áNote, most mutual funds do not charge a sales load fee!

It would be best to avoid funds with sales load, 99.9% of the time you should be able to find a no-load mutual fund in the same category that has similar or even better returns. Study after study have shown that high cost mutual funds on average don’t perform better. When it comes to investing high costs don’t equal better returns or lower risk.

Expense Ratios

Both mutual funds and ETFs have expense ratios. An expense ratio is a fee that covers management, administrative and operating costs. It doesn’t cover trading costs or sales loads (discussed above). When you research expenses you’ll see the expense ratio expressed as a percentage, for example 0.25%, 0.50%, .60%.

If you multiply that percentage by the 1,000 you’ll get what you pay annually for every $1,000 dollars you have invested. For example I own Fidelity’s Small Cap Index Fund (FSSVX) in my retirement account. Its expense ratio (as of 6/25/17) is 0.09%. Multiplying that by 1,000 equals $0.90, or in other words I pay $0.90 for every $1,000 dollars I have invested in FSSVX. If I had $10,000 invested I would pay Fidelity $9.00 for expenses. Goldman Sach’s Small Cap Value Fund (GSSIX) charges a 0.95% expense ratio, which would mean it would cost $95 per year for a $10,000 investment which more than ten times as much as Fidelity. Also note year-to-date GSSIX has returned only 0.55% while FSSVX has returned 3.8%.

Below is a chart illustrating the effects higher expenses can have on your returns. Both Fund A and Fund B start with $10,000. Fund A’s expense ratio is 0.25% and it has no load. Fund B’s expense ratio is 0.50% and it has a load of 4.5%. Remember I shared that studies have shown that higher expenses don’t necessarily equal higher returns, but for the sake of this exercise lets have Fund B’s annual returns be 10% higher than Fund A’s.

Effect of Higher Expenses on Returns

As you can see even with the higher annual returns Fund B cannot overcome Fund A, the expenses are just too high.

Which is Better?

There is no one size fits all instrument for investing. In a 401k they usually only offer mutual funds so there is no need to worry about any ETFs options. In your own personal investment, IRA or rollover 401k account you could decide on purchasing an ETF over a mutual funds depending on a number of factors like costs, performance, risk, allocation, expected time horizon, etc.

For example, suppose you want to add gold to your investment portfolio. You find a quality gold mutual fund but the minimum investment amount is $5,000. If you only wanted to invest $2,000 in gold than you could turn to an ETF where there is no minimum investment.

The key is having a clear understanding the differences and the pros and cons of each. Hopefully if this is all new to you this is a good first step, but don’t let this be your last step! Learning how to make your money work for you is not as hard as many people think.

ThePaperChaser

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