ETFs vs mutual funds
ETFs and mutual funds have a lot in common. For example, both consist of a mix of different assets, allowing investors to diversify their portfolios, but there are a few key differences in the way they’re managed. On this page, you’ll learn what these differences are and find out which might be a good investment for you.
- ETFs are passively managed and usually track a market index, while mutual funds are actively managed by a fund manager who decides what assets to buy or sell
- Mutual funds tend to have higher fees than ETFs because mutual funds incur the cost of having a fund manager
- You can actively trade throughout the day in ETFs, while you can only trade in a mutual fund at the end of trading when the prices are fixed and the market has closed
Table of Contents
What is an ETF?
An exchange traded fund (ETF) is a type of investment where stocks are traded in an exchange market. Although ETFs can invest in any number of industries, they often track a specific index. Stocks in ETFs can typically be bought and sold throughout the day.
ETFs hold assets such as stocks, bonds, commodities, and even currencies, and generally operate on a type of mechanism designed to keep trading close to the asset’s net value, which allows stocks to be bought and sold easily.
What’s a mutual fund?
A mutual fund is a type of financial vehicle made up of a pool of investments, or money collected from many investors. This pool is used to make lump sum investments in stocks, bonds and other assets that show high potential returns. Mutual funds are operated by professional active fund managers, who use the funds to make various investments intended to produce capital gains for the investors.
What’s the difference between an ETF and a mutual fund?
Some of the key differences between ETFs and mutual funds* are the following:
|Exchange traded funds (ETFs)||Mutual funds|
|How they’re managed||ETFs are passively managed funds that track a market index and make profits based on the tracked index performance.||Mutual funds are run by an active fund manager, who usually has a team of analysts who attempt to beat the market.|
|Expense ratio||Passively managed funds are comparatively inexpensive, and some offer expense ratios** as low as 0.3%.||The average annual expense ratio of actively managed funds is around 0.67%. Expense ratios can differ, based on the type of mutual fund you invest in.|
|Making trades||ETFs are traded throughout the day, just like stocks, where the price depends on the supply and demand.||Mutual funds are based on an index which is only priced and traded at the end of each trading day.|
|Minimum investment||ETFs are purchased based on the share price in the exchange market.||Mutual funds typically have a high cost of entry, often a minimum of £1,000 or more.|
An example of ETFs vs mutual funds
As an example of the difference between ETFs and mutual funds, if you redeem £20,000 from your mutual fund, for the fund manager to pay you, they will need to sell £20,000 worth of stock. If stocks are sold to free up this money, the fund can capture the money from that sale as capital gains which will be distributed to shareholders before year-end. As a result, the other shareholders will pay tax on the turnover of £20,000 within the fund.
If you wish to redeem £20,000 from an ETF, the ETF doesn’t need to sell any stock in its portfolio. Instead, it will offer shareholders an in-kind redemption which limits the possibilities of having to pay capital gains. In-kind redemptions are payments for securities rather than money. By issuing in-kind redemption, the ETF doesn’t need to sell anything to raise the money to pay you.
What are the tax implications on ETFs and mutual funds?
Taxes on ETFs and mutual funds are the same as any other investment. You may pay tax when selling your shares for a profit. This tax is called capital gains. In each tax year, you can earn up to £12,000 in profit before having to pay capital gains tax.
You may either pay short or long-term capital gains. Short-term gains apply to shares that you have held for less than a year before selling. Long-term gains are profits from shares sold after you’ve held the shares for more than a year. If you have to pay capital gains tax, it will depend on the income tax bracket you’re in.
Mutual funds often have higher tax implications because they pay investors capital gains distributions.
Is an ETF or a mutual fund right for me?
Both ETFs and mutual funds can be good tools for investors. When choosing one over the other, you should consider what you value most. If you’re looking for low expense ratios and flexible trading capacity, ETFs may be right for you. But, if you worry about the impact of commissions, premiums and any other factor that can affect a share’s value, and you want help in managing them, a mutual fund might be a better choice for you.
Before making a decision, you should always consider the level of risk you’re comfortable with, and it’s best to talk to a financial advisor before signing up to any financial product.
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