Exchange-Traded Funds and Mutual Funds: What's the Difference?
There are numerous tools and instruments out there today that can be made use of to build up a reasonable portfolio of holdings. These include stocks, bonds, currency, and so on. Out of this rich base of instruments evolved other, more sophisticated instruments with their own particular characteristics and functions, such as the exchange –traded fund (ETF).
This refers to a type of security that works by tracking specific trades and indexes found on major stock exchanges. Due to this, ETFs are flexible enough to see potential investors acquire interests in bonds, commodities, and stocks. They share this quality with financial instruments such as common stock and mutual funds. There are plenty of advantages when it comes to investing through ETFs, but it’s always best to have a clear understanding of what exactly they are first. To that end, let’s take a glance at some of the best ETF qualities and how they match or differ from mutual fund characteristics.
Let’s dive right in.
ETF and Mutual Fund Similarities
Looking at this two cousins of the financial instrument world bring’s up a lot of similar qualities, mainly showing up clearly when looked at through the prism of what can be accomplished using the instruments. For instance, many people make the choice to invest through ETFs as this allows them the chance to spread out their capital and broaden their portfolio, which greatly helps reduce their reliance on any single holding. ETFs make this spreading out process a whole lot more manageable, straightforward, and affordable than it would have otherwise been.
Mutual funds will put aside a share of the fund’s value to cater for administrative expenses, which is pretty much the same when it comes to ETFs where an expense ratio (percentage of the ETFs assets) will be diverted towards the fund’s management and related costs.
What Sets ETFs Apart?
There are plenty of qualities setting apart ETFs from mutual funds despite all the similarities they share. Let’s check out a couple of them:
- ETFs are bought and sold on open exchanges much like stocks are, with the price being determined by the supply and demand pressures it experiences. Mutual funds, on the other hand, will come to a set price by calculating it once a day.
- One of the best ETF qualities in the eyes of many is the fact that you buy them on margin, or even carry out transactions using a shorted ETF. This flexibility and liquidity is a major selling point in today’s rapidly changing financial environment, where fortunes can be made and lost in a matter of minutes.
- ETFs have no minimum initial investment requirements such as are commonly found in the case of mutual funds. These barriers to entry will sometimes lock those who can’t afford them out of the financial playing field. With ETFs, all you need to get in the game is the cost of purchasing one share.
For the sake of being thorough, we couldn’t break off a talk about ETFs without mentioning a potential danger when it comes to their brother, the leveraged or inverse ETF. This is a new concept in the financial markets when compared to ETFs, but it has quickly earned itself a reputation as a long term loser even in cases where the underlying asset is doing well.
The bottom line when it comes to these is that they are better left to professional traders and institutions who will know how to properly handle them, rather than the casual investor.
ETFs have come to be considered ideal investments for those who do not have vast reserves of capital they can make use of to create an investment portfolio, especially the younger generations. They are easily traded and provide a very convenient alternative to other, more traditionally conservative investment avenues offered by today’s financial institutions. A good piece of advice to take away with you is that ETFs are designed to work to best effect when purchased as long-term holdings, even though they may be easily bought and sold on the open market.
Remember that even the best ETF investment still calls for careful consideration and the requisite due diligence on your part if you are to achieve your financial investment goals.