This year, we launched our financial education series. The purpose was to educate investors on various aspects of dividend investing or just investing in general. Some articles have been as fundamental as “What is a Dividend?” while some articles took a deeper dive into a topic, such as “What is a REIT and How Are Dividends From a REIT Taxed?” Today’s article will take a step out of the dividend specific topic and explain the differences between mutual funds and ETFs. Both types of investments are important diversification options and are similar (but with some key differences). And of course, as you would expect, there will be a dividend twist at some point in this article! Let’s start peeling back the layers!
Before we start diving into the details, let’s first define what mutual funds and ETFs are. For this, let’s pull in the Investopedia.com definition:
- Mutual Fund – A mutual fund is an investment vehicle made up of a pool of money collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments and other assets. Professional money managers operate mutual funds. The managers allocate the fund’s investments and attempt to produce capital gains and/or income for the fund’s investors. A mutual fund’s portfolio is structured and maintained to match the investment objectives stated in its prospectus.
- Exchange-Traded Funds, or ETFs – An ETF, or exchange-traded fund, is a marketable security that tracks an index, a commodity, bonds, or a basket of assets like an index fund. Unlike mutual funds, an ETF trades like a common stock on a stock exchange. ETFs typically have higher daily liquidity and lower fees than mutual fund shares. Thus, making them an attractive alternative for individual investors.
similarities between mutual funds and etfs
Based on the definitions, there are clearly some similarities between the investment options. Here are some of the main similarities:
- Holdings – Both mutual funds and ETFs consist of a pool of different stocks, REITs, or other investments outlined by the funds objectives.
- Types of Funds– Mutual funds and ETFs are pools of stocks and different investments. As a result, each can take many different shapes and forms. Each offer a diversified selection of funds. For example, there are funds that mirror any stock index (S&P, NASDAQ, international indices, etc.), domestic focused, international focused, high growth oriented, etc. There are even funds that mirror certain industries, such as utility funds, REIT funds, consumer staples, industrials, etc. There are equity and bond funds. Strategies of the funds can be as specific or general as an investor would like. Chances are, there is a mutual fund or ETF to help you achieve your investment goal.
- Zero-Commission Trades at Certain Brokerages – I found this fact interesting as I was performing research for this article. Places such as Vanguard, Fidelity, and other investment brokerages are offering zero-commission trades on all mutual funds and ETF transactions. Assuming of course, you purchase their mutual funds or ETFs. These places value keeping capital in their product offerings and are offering a nice free-trade incentive to do so.
differences between mutual funds and etfs
Sure, there are some similarities between the two. But even though mutual funds and ETFs are similar, there are plenty of differences. After all, if there weren’t, why would we be writing this article? Here is a listing of some of the major differences between mutual funds and ETFs.
- How Mutual Funds and ETFs are Traded – This one is a pretty large difference. Mutual funds only trade once per day. You may place a buy or sell trade during the day; however, the trade won’t occur until after the market closes. The trade is based on the mutual fund’s Net Asset Value (NAV) at the end of the day. Conversely, ETFs trade like a stock. You can buy and sell an ETF at any point during trading hours.
- Trading Fees – ETFs trade like stocks. Brokerage’s charge their standard trading fee accordingly. Unless your brokerage offers free ETF transactions as discussed above. For mutual funds, the transaction fees are not as straight forward. I mentioned earlier that you may be able to purchase a mutual fund at Vanguard with no trading fees if you invest in a Vanguard mutual fund. But what if your brokerage account does not offer mutual funds? Or, you would like to invest in a mutual fund family such as American Funds, Aberdeen, Oppenheimer, etc.? Then you may find yourself paying fees to transaction. I’ll use American Funds as an example. American Funds offers no-load (commission free discussed earlier) and “load” (charges commission) funds. If you opt to invest in a load mutual fund, you will either be charged a commission at the time of your initial investment (Front-end) or when you withdraw your funds (back-end). Thus, it is critical to understand when you will be charged a commission fee and what the percent fee is.
- Minimum Initial Investments – Each mutual fund and fund family is different. Each mutual fund has a different minimum investment. The minimum investment can be as small as a $0 or thousands of dollars. It just depends. ETFs trade like stocks. So the minimum ETF investment is 1 share.
- Active Vs. Passive Management – Both mutual funds and ETFs are professionally managed. However, mutual funds are typically “Actively” managed while ETFs are “passively” managed. What does this mean? Active managers closely monitor the investments. They are potentially trading to beat the market when opportunities arise. Of course with this style of management comes higher trading fees, commissions, etc. Which is a perfect segue into our next bullet point.
- Lower Expense Ratios for ETFs (For the Most Part) – I want to throw in a massive disclaimer here. This does not include the low cost, index mutual funds offered by Vanguard, Fidelity, etc. Those expense ratios are difficult to beat. This refers to other mutual funds. In April 2018, ICI issued a report on the trends in expense ratios for mutual funds and ETFs. The average expense ratio of a long-term, equity focused mutual fund was .57% compared to .21% for similar ETFs in 2017. That is a pretty significant disparity. The more complex the fund’s objectives are, the higher the expense ratio will become. So with more active management comes higher annual expenses on the funds.
- Taxation Differences – This was another interesting tidbit I found while performing research for this article. For both mutual funds and ETFs, dividends and distributions are taxed as a capital gain. So what is the difference? There are more taxable events to mutual fund investors due to trading frequency. Based on the nature of the accounts, you may incur a higher tax liability if investing in a mutual fund. This isn’t an absolute rule/guarantee. But I did find this interesting to say the least.
This isn’t the complete listing of differences. If I excluded a difference, or you would like to provide your thoughts or opinions on one of the items above, please do so in the comment section of our article!
Are there dividend focused mutual funds and ETFs?
Come on, we are dividend growth investors here. Naturally we can’t have one article without discussing dividends, right? Earlier, I discussed that mutual funds and ETFs can achieve almost any objective imaginable. Plenty of funds offer Dividend Focused mutual funds and ETFs. Here are some dividend focused funds. As with any investment decision, please perform your own research to determine if the specific fund invests in companies that match your objectives and risk profile.
- Mutual Funds –
- VDIGX – Vanguard Dividend Growth Fund
- CDOYX – Columbia Dividend Opportunity Fund
- FSDIX – Fidelity Strategic Dividend & Income
- PRDGX – T. Rowe Price Dividend Growth Fund
- DDFIX – Invesco Diversified Dividend R5
- ETFs –
- VIG – Vanguard Dividend Appreciation
- SCHD – Schwab U.S. Dividend Equity
- VYM – Vanguard High Dividend Yield
- DVY – iShares Select Dividend ETF
- SPYD – SPDR Portfolio S&P 500 High Div
For other options, Dividend.com compiled a comprehensive listing of different dividend-focused ETFs and mutual funds. Please also share your dividend focused mutual funds and ETFs in the comments section!
Do we Invest in Mutual Funds and ETFs?
Of course we do. Our exposure is predominately in our 401k plans. Lanny has invested in a few ETFs outside of the employer sponsored plans, VGK for example. However, Bert has not. Here is a link to our individual portfolios if you would like to see the specific funds we selected.
Hopefully you have found this article helpful. As you can see, while there are some similarities, there are plenty of differences between mutual funds and ETFs. If you have any other ones you would like to include, please do so in the comment section!
-The Dividend Diplomats