Mutual funds and ETFs: Understanding the difference

When building your portfolio, it’s important to choose a mix of investments that reflect your comfort with risk, time horizon and long-term objectives. But what if you don’t have the time or the patience to research each stock or bond individually before you invest?

A mutual fund or an exchange-traded fund (ETF) may be able to help you diversify your portfolio through a single investment.

What is a mutual fund?

When you invest in a mutual fund, your money is pooled with that of other investors. A professional money manager or management team then invests the money into a variety of securities to help the fund meet its stated objective, such as generating current income or seeking long-term growth.

Mutual funds typically have low minimum investments and are traded only once a day at the closing net asset value (NAV).

Potential benefits of investing in mutual funds

Diversification — Most mutual funds own a wide variety of investments in their category. Funds cover most major asset classes such as stocks, bonds and real estate, as well as sectors such as consumer staples, energy, health care, etc.

Professional management — Fund managers can adjust the portfolio mix based on changes in market conditions or a company’s performance to help the fund achieve its stated objective.

Convenience — You can buy or sell your fund shares on any business day and automatically reinvest any dividends and capital gains distributions. You also can exchange funds within a fund family without fees.

Drawbacks to owning mutual funds

Taxes — Most mutual funds are actively managed, which means managers trade to try to outperform the market. This can trigger more capital gains distributions. Also, mutual funds may be forced to pass along capital gains to shareholders, which could make them less tax-efficient than ETFs.

Fees and expenses — A mutual fund’s management and operating expenses are factored into the total return you receive each year. Also, some funds charge a one-time commission (known as a load) or a trading fee whenever you buy or sell your shares. Actively managed mutual funds, which strive to beat market returns, can incur higher fees than passively managed funds due to frequent buying and selling.

What is an ETF?

An exchange-traded fund (ETF) is like a mutual fund in that it holds a variety of securities in one investment.

But while most mutual funds are actively managed, ETFs are generally passively managed. This means the fund managers strive to mimic — rather than beat — a specific index (such as the S&P 500), replicating its holdings and, hopefully, its performance.

ETFs also differ from mutual funds in that they trade on an exchange, experiencing price changes throughout the day.

Potential benefits of investing in ETFs

Diversification — As with mutual funds, most ETFs invest in a diversified portfolio of individual stocks or bonds.

Lower costs — ETFs that track broad market indexes don’t have to pay portfolio managers to analyze and trade shares for the fund. They typically can be operated at lower costs than mutual funds.

Tax efficiency — Because ETFs generally trade less often than mutual funds, they tend to generate fewer transactions that are taxable, which means potentially fewer expenses for investors. Their structure means they can avoid passing capital gains taxes on to shareholders.

Drawbacks to owning ETFs

Narrower diversification — Some ETFs are narrowly focused, meaning they’re more dependent on a certain type of company or an individual country. A narrowly focused ETF may offer less diversification for your portfolio than a mutual fund.

Extra costs — Because ETF shares trade on stock exchanges, every time an ETF share is bought or sold, the fund may incur a broker’s commission.

Ready to invest in an ETF or mutual fund? Edward Jones can help

As with any other investment, a mutual fund or an ETF may be a good investment overall — but not if it doesn’t match your investing time horizon and comfort with risk. Also, any investment you choose should serve a purpose in your portfolio, such as saving for or providing income in retirement.

Your financial advisor can go over the pros and cons of investing in mutual funds and ETFs with you to help ensure they’re right for your situation and goals.