How do investment funds work?
Investment funds, such as mutual funds and ETFs, are a collection of securities within a single investment vehicle. Investor funds are pooled together through the fund to purchase those securities, giving investors a diversified holding while only having to make a single purchase.
In this way funds are a great way to hold multiple stocks or other investments without having to individually purchase each one.
What is a mutual fund?
A mutual fund is a professionally managed fund that invests in securities such as stocks, bonds and other assets. Mutual funds typically have an objective, or benchmark, they are trying to beat, such as the S&P 500.
- Actively managed mutual funds have an investment team and fund manager that make trades in an effort to improve customer returns.
- Passively managed mutual funds track an index, such as the Nasdaq 100, and typically have lower fees since a full management team is not required.
Mutual funds usually have a high minimum investment, but once you purchase one, you can then invest whatever amount you want. This allows simple dollar-cost averaging so you don't have to purchase a whole share of the mutual fund each time.
Actively managed mutual funds are known for high fees, as there is much more involved in managing these funds versus a passive fund.
What is an ETF?
ETFs are low-cost funds that can be traded just like an individual stock. There is no minimum investment required, and investors can purchase ETFs for the price of one share. ETFs can also be bought and sold during market hours, making them more liquid and useful to active market traders.
Similar to mutual funds, ETFs contain securities such as stocks, bonds and other assets. Some ETFs can be actively managed, but a majority just track a market index (such as the S&P 500). Due to their mostly passive nature, ETFs are known for having extremely low fees as well.
» MORE: What is a good investment?
Key differences between a mutual fund and ETF
“Mutual funds and ETFs are both investment vehicles,” said Ross Dugas, the founder of Scientific Financial. “In some cases, they may follow the same index or hold the same stocks and seem interchangeable. However, mutual funds and ETFs have two key differences.”
According to Dugas, the main differences between the two are how they trade and how they are taxed:
- Trading: “ETFs trade like stocks (instantaneously). You buy shares at their market price. Mutual funds orders are processed only at the end of the day, and purchases are based in dollars, not shares,” Dugas said.
- Tax efficiency: “Mutual fund investors pay capital gains tax on assets sold by their funds (even if you didn’t sell),” Dugas said. “ETF owners pay capital gains tax only when they sell their shares.”
There are a few other differences to know about. Here’s how mutual funds and ETFs compare:
| Mutual funds | ETFs | |
|---|---|---|
| Assets | Stocks, bonds, commodities, etc. | Stocks, bonds, commodities, etc. |
| Fund management | Mostly active management | Mostly passive management |
| Fees | Higher expense ratios; may have sales commissions (loads) | Low expense ratios; no sales commissions |
| Trading window | End of trading day only | Intraday trading available |
| Taxes | Turnover within fund may cause capital gains taxes | Fewer taxable events |
Which fund is right for you?
If you are considering investing in a mutual fund or an ETF, there are a few things you should consider first.
Fees
Mutual funds are notorious for high fees, with higher expense ratios than many ETFs, as well as sales commissions on some actively managed funds. If you want lower fees, in most cases, ETFs are the better choice.
Investing goals
Many mutual funds have specific objectives and goals that are listed in the fund prospectus. In the case of actively managed funds, you can choose a fund that fits your investing goals, which may be steady income, less volatility or growth. But if you simply want to follow an index or to actively trade funds, an ETF may suit those goals better.
Tax efficiency
In general, ETFs are more tax-efficient, so if you are looking to minimize taxes in a taxable investment account, then an ETF may be a better choice. But if you are investing in a tax-advantaged account, such as an IRA, you may not care as much about tax efficiency and can choose either a mutual fund or an ETF.
Performance
The bottom line in investing is the long-term performance of your funds. It is important to consider the historical performance of any mutual fund or ETF before investing. While past performance doesn’t indicate future results, it can help give context on how the fund may perform over time.
How to invest in a fund
You can invest in mutual funds and ETFs at most major online brokers. Companies such as Vanguard, Fidelity and Charles Schwab have their own mutual funds you can choose from, as well as a host of ETFs you can choose to invest in.
It’s important to note the minimum investment on any mutual fund you wish to purchase.
To buy a mutual fund, you will need to create an account with the investment firm that holds the fund you want to purchase. Once your account is set up, you’ll need to transfer over funds from your bank account. Once the funds are transferred, you can buy the mutual fund. After you’ve met the minimum investment for the mutual fund, you can then set up recurring purchases at any dollar amount above the broker’s minimum investment.
To buy an ETF, you’ll need to open an account with an online broker and transfer funds from your bank account. You can then purchase the ETF for the price of one share. Your purchase will execute immediately as long as the market is open. If you attempt to purchase an ETF before or after market hours, the trade will typically execute once the market reopens.
» MORE: How to buy stock
FAQ
Is a mutual fund the same as a stock?
A mutual fund is not the same as a stock but is rather a collection of stocks or other securities within a single investment fund. This allows investors to own several stocks (even hundreds) by purchasing a mutual fund.
Is an ETF the same as a stock?
ETFs and stocks are not the same. While an individual stock represents equity ownership in a company, an ETF is a fund that owns several stocks, bonds or other securities within a single investment vehicle. ETFs allow you to own a basket of stocks or other assets inside the fund. You can actively trade ETFs just like stocks.
What is an index fund?
Index funds are a type of mutual fund or ETF that mirrors the investments represented by a stock market index. For example, an S&P 500 index fund holds the same investments that the S&P 500 index tracks. This allows investors to get the same returns as a particular stock market index, and the fees are typically much lower than actively managed funds.
Bottom line
Mutual funds and ETFs help investors diversify by allowing them to own a wide range of investments within a single fund. But while mutual funds typically require a higher minimum to invest and can come with high fees, ETFs let you purchase just one share and typically have lower annual fees.
Mutual funds can be a good investment for some portfolios, while ETFs let you diversify your investments for less. Overall, choosing one over the other depends on your investing goals, timelines, risk tolerance and investing needs.
Article sources
- S&P Dow Jones Indices, "S&P 500." Accessed Nov. 10, 2023.
- Nasdaq, "Nasdaq-100 Index." Accessed Nov. 10, 2023.
- Investor.gov, "Mutual Fund Fees and Expenses." Accessed Nov. 10, 2023.
