What are the Differences Between Mutual Funds and ETFs?

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!

Definitions

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. Mutual funds are operated by professional money managers, who 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 experience price changes throughout the day as they are bought and sold. ETFs typically have higher daily liquidity and lower fees than mutual fund shares, 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 FundsSince mutual funds  and ETFs are pools of stocks and different investments, 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.  Typically we are equity investors; however, there are plenty of bond funds offered as well.  Strategies of the funds can be as specific or general as an investor would like.  If there is a certain investment objective you would like to achieve, changes are there is a mutual fund or ETF to help you achieve that 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 are traded once per day.  You may place a buy/sell trade during the day; however, the transaction won’t be completed until the end of the day.  The trade is based on the mutual fund’s Net Asset Value (NAV) at the end of the day.   Conversely, ETFs are traded like a stock.  You can buy and sell an ETF at any point during the day.  So if you placed the buy/sell order at 10:30 AM, your trade will be executed at that time.
  • Trading Fees – Since an ETF is traded like a stock, typically, investors will be charged your brokerage’s trading fee for the transaction.  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 is at Ally or another brokerage that does not offer not trade 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, if you select this option, 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.  Since ETFs are traded like stocks, an investor can purchase whatever quantity of the fund they would like.  Typically, the minimum investment would be 1 share of the desired ETF.
  • 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 are closely monitoring the investments and potentially trading to beat the market when opportunities are spotted.  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.  In 2017, the average expense ratio for a long-term, equity focused mutual fund was .57% compared to .21% for similar ETFs.  That is a pretty significant disparity.  The more complex the fund’s objectives are, the higher the expense ratio will become as the mutual funds incur more trading fees, research costs, etc.  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.  Both dividends and distributions by mutual funds and ETFs are taxed as a capital gain.  So what is the difference?  Since mutual funds are typically more actively managed and have higher trading volumes, there will be more taxable events to investors.  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.  So if you think a difference between the two was excluded 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 in the article, it was mentioned that mutual funds and ETFs can achieve almost any objective imaginable.  Plenty of funds offer Dividend Focused mutual funds and ETFs.  While we don’t invest in these specifically, here are some of the advertised 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.  Although, our exposure is predominately through employer sponsored mutual funds offered 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.

Summary

Hopefully you have found this article helpful and a great starting point if you are looking to invest in mutual funds and exchange traded funds.  As you can see, while there are some similarities between the two investment options, 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

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4 thoughts on “What are the Differences Between Mutual Funds and ETFs?

  1. I have tended to get my international dividend equity exposure from funds and ETFs while focusing on individual dividend stocks from the US. I think all of these options can play a valuable role in a diversified portfolio with the objectives of income, income growth and capital appreciation (my 3 overarching investment objectives). In the international space, I own PID and DWX (both ETFs) as well as MAPIX (a traditional mutual fund). Tom

    • Thanks for the comment Tom. Interesting approach and I like it. Especially since my expertise is more with domestic stocks and I do not follow the international markets as closely. But having the etf/MF exposure would allow you to capitalize on the great international dividend stocks that are out there and help you achieve diversification. I dig it!

      Bert

  2. I have a similar approach as Tom in that my international exposure really comes via mutual funds in my retirement accounts, and therefore my individual stock investments are focused on the US market. When building my DGI portfolio, I did include VYM and plan to continue holding that as I build my portfolio. Having come from a history of being invested in primarily index funds and mutual funds via 401(k) account, I felt more comfortable having the ETF as part of my holdings.

  3. Thanks for your time explaining the differences. I’m not really into ETF’s at the moment but investing some of my money in a financial ETF or healthcare ETF during the next economic crisis has crossed my mind regularly as a nice alternative for investing in individual stocks. Why? Because I don’t want to miss out on so many good alternative businesses trading for sale prices during those days when blood is running through the streets.

    Thanks again 👍

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