What is an ETF?

By: Jilly Pretzel

An ETF (or exchange-traded fund) is a selection of securities funded by pooling investors’ money. ETFs have enjoyed a lot of buzz over the past decade, with some equating them to a new, and perhaps improved, version of a mutual fund. But ETFs aren’t necessarily a better option for every investor.

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1. What is a Mutual Fund?

A mutual fund is a collective pool from investors, operated by money managers who create a diverse portfolio with the funds. Think of it as people coming together to put their money together for stronger investments and lower risk.

The risk is lower because funds are invested in various securities (such as stocks and bonds) so if one investment does poorly, another investment will likely do well and even it out. This means the investors will have lower risk and (hopefully) high reward.

The manager of the mutual fund is usually hired by a board of directors and is a partial owner. Because an expert is in charge of the funds, investors enjoy the benefit and convenience of a professional devoting their time to researching where to allocate funds, without having to actively stay up on the market.

Mutual funds can only be traded once a day at the Net Asset Value (NAV) price, which is the value of fund assets, minus the liabilities, divided by its number of shares.

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Mutual funds and ETFs are similar in that they both involve pooling money to create a fund invested in a diverse portfolio of securities. However, there are important differences between the two.

a. One important difference is that ETFs are usually more financially accessible.

For one thing, ETFs usually have a lower expense ratio than mutual funds. Expense ratios pay for management fees and other expenses and these rates are usually higher for mutual funds. In 2017, the average expense ratio of actively managed mutual funds was 0.59 percent while the average expense ratio for ETFs was 0.21 percent, according to the Investment Company Institute. This means that for every thousand dollars you have invested in a mutual fund, you’d pay $5.90 a year, while with an ETF, you’d only pay $2.10 a year. This may not sound like a lot, but these fees can really add up.

Also, while many mutual funds require hefty minimum investments, ETFs have no minimums which allows you to buy as little or as much as you want. You can even start out with a single share.

b. While it may be cheaper to get started with ETF, mutual funds don’t have the same fees ETFs do when trading. Because ETFs are traded like stocks, you should expect to pay a commission when buying and selling.

c. Another difference is while mutual funds can only be traded at the end of the day at the NAV price, ETFs can be traded throughout the day like stocks.

d. Finally, while mutual funds are usually actively managed, with a fund manager working to allocate funds in the most financially beneficial way, ETFs are purchased simply to track an index. With an actively managed mutual fund you get the benefit of a professional devoting time to find the best opportunities. However, this does make room for human error and if a fund manager isn’t great, you might be better off with the ETF.

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3. Is an EFT right for you?

Knowing whether an ETF is right for you depends on your financial situation and your investment goals. Some major advantages of an ETF are that there are no minimums and generally smaller fees, so it won’t cost you very much to get started in the market. Plus, ETFs provide more flexibility for trading.

However, going with a mutual fund might be worth the extra expense because for the benefit of a professional to manage the funds. It’s a great way to passively make your money grow and could mean big earnings in the future.