A mutual fund is an investment vehicle that invests in securities and assets in order to achieve a return roughly the same as that of the underlying stock index or target asset class. Unlike an Exchange-traded fund that trades throughout the day, a mutual fund trades at the net asset value (NAV) determined at the end of each trading day. While ETFs provide certain advantages, mutual funds do serve purposes that ETFs do not. Investors must decide depending on their financial and investment goals which types of funds work best for their portfolio.
ETFs Vs. Mutual Funds
One of the principal reasons that some investors will prefer an ETF to a mutual fund or index fund is because of tax advantages and cost savings. A mutual fund marks all of its positions to market at the end of each year, while an ETF, because it trades like a stock, does not. In essence, an ETF is treated like a stock and a mutual fund is treated like a fund. Because of this feature, it is impossible to avoid short-term capital gains inside a mutual fund. Holding an ETF for an extended period can avoid these gains and be treated as long-term gains instead.
On the other hand, an actively managed mutual fund is overseen by a professional money manager and will avoid some of the shortcoming on an ETF. In extreme markets, ETFs may begin to trade at a premium to their underlying index. For the investor who simply wishes to track the index, this premium represents an additional and unwanted cost. This problem is avoided with a mutual fund.
Trading Mutual Funds and ETFs
In the current environment, the most common place where a typical investor will purchase a mutual fund is in a retirement account like a 401(k) or an IRA. Many 401(k) accounts allow participants to select between various mutual fund options. Because tax consequences are not a primary concern in a retirement account, the different treatment that an index fund gets should not matter. At this point, the primary concern in selecting a mutual fund should be the strategy and the expense ratio. The advantages of an index fund are that they will have low expense ratios and will not rely on the skill of a particular individual to achieve returns. If the underlying market goes up, as most tend to do over the long-term, the investor in an index fund will get a pure return with low costs.
ETFs, however, are more readily available in brokerage accounts because they trade like common stock. This allows traders and investors to use ETFs for more short-term strategies. Depending on the fund, ETFs also can help to lower expense ratio as well.
