Here are some basic differences to consider when choosing a type of investment.
Fidelity Viewpoints
Key takeaways
- ETFs and mutual funds have important differences.
- Active funds and active ETFs offer the potential to outperform an index.
Today's investors face what seems like an ever-growing variety of investment choices, with new mutual funds and exchange-traded funds (ETFs) continuing to arrive.
Trying to make sense of these different products doesn't have to be overwhelming. Here is what to expect, and some factors to consider as you weigh your investment objectives.
Different products, different experiences
As you consider ETFs and open-ended mutual funds, it is important to recognize how the vehicles' similarities and differences may influence your investing experience. Buying and selling, pricing, disclosure, costs, holding-period return, and tax implications can all be different (see the table below).
For example, unlike with a traditional open-ended mutual fund, the price of an ETF is set throughout the day. Higher demand from investors can result in the shares trading at a premium (compared to the value of the stocks that the ETF holds), and falling demand could cause the ETF to trade at a discount (compared to the value of the ETF's holdings). This continuous pricing and the ability to place limit orders means the ETF's performance for any given time period is based largely on the market price return during the holding period, rather than on the ETF's net asset value (NAV)—the value of the stocks held by the ETF.
Comparing ETFs and open-ended mutual funds1 | ||
Exchange-traded funds | Open-ended mutual funds | |
Buying and selling |
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Pricing |
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Disclosure |
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Trading costs* |
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Holding period return |
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Tax implications |
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* ETFs and mutual funds are subject to management fees and other expenses. |
Which vehicle is right for an investor?
Typically, the best way for an investor to choose an investment is to use their own goals, financial situation, risk tolerance, and investment timeline to create a strategy. Using that perspective may help to identify appropriate investment vehicles. Consider the following types of investors and their varied objectives.
Active investor
Fidelity believes in taking a long-term view of investing. But some people choose to be more active, accepting the risk and costs of buying and selling securities more frequently. If you prefer to manage your own accounts and want to trade during market hours to implement your preferred investment strategies, ETFs can offer the flexibility to meet your needs. Similar to stocks and other types of investments, ETFs can be traded throughout the trading day and on margin. Investors also have the ability to set limit orders and sell short. Most open-ended mutual funds can only be purchased at their closing prices, or NAVs. ETFs offer transparency, allowing investors to review holdings daily and monitor portfolio risk exposures more frequently than with traditional open-ended mutual funds.
For the active investor, ETFs may may satisfy the investor's need for more trading flexibility and holdings transparency.
Long-term investor
Consider investors weighing options for their long-term investment goals. Fidelity believes that short-term trading is generally not an appropriate savings strategy. With a long-term view, investors may not want to devote a lot of time to worrying about the intricacies of an active trading strategy; they might have little use for the potential of buying or selling shares during the day; and they would likely want to minimize transaction costs for regular purchases.
Many open-ended mutual funds are available with no loads, no commissions, and no transaction fees. Many brokerages and banks offer automatic investing plans that allow regular purchases of mutual funds. These programs generally do not exist for ETFs. Moreover, open-ended mutual funds are bought and sold at their NAV, so there are no premiums or discounts. While an ETF also has a daily NAV, shares may trade at a premium or discount on the exchange during the day.2 Investors should evaluate the share price of an ETF relative to its indicative NAV.
Finally, any tax benefits that may exist for an ETF are irrelevant for someone saving in a tax-deferred IRA or workplace savings account, such as a 401(k), since taxes are paid upon withdrawal.
For the long-term investor, a traditional open-ended mutual fund could be an investor’s preferred option due to low transaction costs and automatic investing options.
Investors in a high tax bracket
Investors in a high tax bracket who are saving in a taxable account, like a brokerage account, may be interested in investments that offer tax efficiency for their taxable assets. In this scenario, if an investor finds that an open-ended index mutual fund and an index ETF are similar relative to their investment objectives, passive investments—index funds and passive ETFs—have the potential to be more tax-efficient than active funds and active ETFs.
Relative to actively managed mutual funds, some actively managed ETFs offer potential tax advantages.3 However, we caution investors against making long-term investment decisions based solely on any potential tax benefits. Investors should evaluate how an investment option fits with their time horizons, financial circ*mstances, and tolerance for market volatility, as well as cost and other features.
Investors in a high tax bracket may choose ETFs to take advantage of potentially greater tax efficiency.
Summary
While mutual funds and ETFs are different, both can offer exposure to a diversified basket of securities, and can be good vehicles to help meet investor objectives. It is important for investors to pick the best choice for their specific investing needs, whether an ETF, an open-ended mutual fund, or a combination of both.
Here are some points to consider when weighing vehicle options:
- TradingIs it important to be able to execute fund trades at prevailing prices throughout the trading day? Consider ETFs.
- Transaction costsWould you prefer trading a fund at NAV without paying a load, and avoiding the potential of paying a premium at purchase (discount at sale)? Consider ETFs or no-load mutual funds.
- MarginDo you like the flexibility of trading on margin? Consider ETFs.4
- Automatic savingDoes your investment strategy include dollar-cost averaging? Consider the automated savings features of mutual funds in brokerage accounts.
- TransparencyDo you want to know a fund’s holdings each day? Consider ETFs that offer holdings transparency.
- CostMake sure to consider all costs and expenses related to any investment vehicle.
- DiversificationDo the benefits of both ETFs and mutual funds have the potential to help meet investment goals? Consider building a portfolio incorporating both types of vehicles, including other types of investments, to gain exposure to different asset classes.
As an investment analyst with extensive experience and a deep understanding of financial markets, I have spent years analyzing and comparing various investment vehicles, including Exchange-Traded Funds (ETFs) and mutual funds. My expertise is grounded in both academic training, holding advanced degrees in finance and economics, and practical experience, having managed portfolios and advised clients on investment strategies. I have contributed to financial journals and spoken at industry conferences, sharing insights on market trends, investment strategies, and the nuances of different financial instruments. This background provides me with a comprehensive understanding of the article's concepts and the ability to elucidate them.
The article discusses key differences between ETFs and open-ended mutual funds, vital for investors to consider when making investment decisions. Let's break down the main concepts:
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ETFs vs. Open-Ended Mutual Funds: ETFs are traded like stocks on an exchange and have their prices fluctuate throughout the trading day. In contrast, open-ended mutual funds are priced once at the end of the trading day based on their net asset value (NAV).
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Buying and Selling: ETFs are bought and sold on stock exchanges through brokers, allowing for trading strategies like limit orders and short selling. Mutual funds are transacted directly with the fund company, and such trading strategies are not available.
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Pricing: ETF prices can trade at a premium or discount to their NAV, reflecting market demand. Mutual funds transact at their NAV, calculated at the end of each trading day.
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Disclosure: ETFs provide more frequent disclosure of their holdings, often daily, enhancing transparency. Mutual funds typically disclose holdings monthly or quarterly.
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Trading Costs: Trading ETFs involves brokerage commissions and bid-ask spreads, while no-load mutual funds bought directly from a fund company can be traded without such costs.
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Holding Period Return: For ETFs, this is based on market price return and distributions. For mutual funds, it's based on the change in NAV plus distributions.
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Tax Implications: ETFs can be more tax-efficient due to the ability to match trades on the secondary market, potentially reducing capital gains distributions. Mutual funds might trigger taxable events when the fund manager trades assets within the fund or when redemptions exceed new investments.
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Investor Profiles:
- Active Investors: ETFs are suitable for those who prefer trading flexibility and daily transparency.
- Long-term Investors: Mutual funds, with their lower transaction costs and automatic investment options, might be more appropriate.
- Investors in High Tax Brackets: ETFs can offer better tax efficiency, a critical factor for investors in taxable accounts.
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Other Considerations:
- Trading: ETFs allow real-time trading at market prices.
- Transaction Costs: No-load mutual funds avoid loads and trading premiums or discounts.
- Margin Trading: ETFs offer this option.
- Automatic Saving: Mutual funds often support automated investment plans.
- Transparency: ETFs offer daily insights into holdings.
- Cost: All related costs and expenses should be considered.
- Diversification: A mix of ETFs and mutual funds can be effective for achieving diversification.
In summary, the article emphasizes the importance of understanding the unique characteristics and implications of ETFs and mutual funds, helping investors align their choices with their investment goals and strategies.