In this article, we’ll cover:

• Similarities between ETFs and mutual funds
• Differences between ETFs and mutual funds
• Choosing the right fund for you

Similarities between ETFs and mutual funds

You can think of any fund, whether an ETF or mutual fund, as a basket of securities. When you buy shares of a fund, you’re investing in all of the assets it holds. The fundamental ways in which ETFs and mutual funds work is quite similar: 

• Diversification: Each type of investment vehicle holds a collection of different securities or asset classes, which can be an efficient way to add diversity to your portfolio.
• Fees: Both ETFs and mutual funds have some fees associated with them, such as transaction or management fees. 
• Investing strategy: Every fund has a particular strategy that guides the investments it holds. You can choose funds associated with industry sectors, geographic regions, investment approaches, and more.
• Liquidity: Both ETFs and mutual funds are generally quite liquid, meaning you can sell your shares for cash relatively quickly
• Risk: All investment comes with risk, including the risk that you could lose money. ETFs and mutual funds are no different, and the risks vary depending on each individual fund. 

Differences between an ETF and a mutual fund

On the surface, ETFs and mutual funds seem very much the same. But understanding the key differences can help you make the appropriate investment decision for you. Mutual funds and ETFs differ in terms of their trading flexibility, minimum investing requirement, management style, costs and fees, and tax efficiency.

Trading flexibility

ETFs can be bought and sold on an exchange, just like individual stocks. That means their prices fluctuate throughout the trading day along with the market. On the other hand, mutual fund prices are calculated at the end of each trading day. This calculation, known as the net asset value, or NAV, is the per-share value of a mutual fund’s assets minus its liabilities. Instead of purchasing mutual funds on an exchange, investors buy and sell mutual fund shares directly from the fund or from a brokerage that sells the fund.

Minimum investing requirement

In general, mutual funds require a minimum investment amount. Minimums will vary depending on the specific fund, but they can be several thousand dollars. Many funds allow the purchase of fractional shares, meaning you can purchase just a portion of a share instead of a whole one, you’ll generally still have to invest the minimum required amount of money. In contrast, ETFs can be purchased as single shares, so there is no minimum required beyond the cost of a single share. Fractional shares are usually available as well.

Management style

Mutual funds tend to be associated with an active management style that involves frequent buying and selling to outperform a specific benchmark or index. An actively managed mutual fund typically has a portfolio manager and other team members who use their expertise to make ongoing decisions about the fund. ETFs, in contrast, are usually associated with a passive management strategy that does not require a decision-making team because the fund is built to track an index like the S&P 500 or the Dow Jones Industrial Average.

Cost and fees

Mutual funds tend to have higher management fees because they are actively managed by portfolio professionals. They’re also likely to have higher transaction fees due to the frequency of trading. ETFs generally have lower expense ratios than mutual funds. Many ETFs trade for free, though some may require a commission. Transaction fees are typically lower for ETFs, and they don’t carry sales load or redemption fees like mutual funds.

Tax efficiency

Generally speaking, the overall operations of an ETF are more tax-efficient than mutual funds. Due to the way ETFs are structured, they often sell shares in a manner that triggers fewer taxable events. Mutual funds pay investors capital gains distributions, so their tax implications tend to be higher. 

Choosing the right investment fund for you

There is no “one size fits all” answer to investing. Choosing the type of investment fund that’s right for you takes careful consideration. Take the time to assess your investment goals, risk tolerance, and preferences about how involved you want to be in the day-to-day management of your investments. 

• Investment goals: Knowing whether your investment goals are long-term, like saving for retirement, or shorter-term, like saving for a home purchase, will help you determine the type of investments that make the most sense for you. 
• Risk tolerance: Reflect on the level of risk you’re comfortable with. Are you a conservative investor who prefers more stability, even if that leads to lower returns? Or are you comfortable with a more aggressive investing style that takes on more risk of volatility in the hopes of higher returns?
• Level of involvement: Are you more of a hands-on investor or a “set it and forget it” investor? Actively managed funds, like mutual funds, take more effort and direct involvement than passively managed funds, like most ETFs. 

Additionally, it’s important to evaluate the fees, expenses, and performance history associated with any particular fund. Mutual funds and ETFs will each have a prospectus that outlines investment objectives, risks, fees, expenses, and other information that you should read and consider carefully before investing. 

• Fees and expenses: A fund’s fees and expenses can add up quickly. Consider the benefits and drawbacks of every expense that may come along with choosing an investment fund. Remember that while ETFs tend to have lower fees than mutual funds, every fund is unique, so check on the fees for every fund you’re considering. 
• Fund performance and history: Historical data can show you how a fund has performed over time, how well portfolio managers have handled previous ups and downs, and offer some insight into how the fund may perform in the future. 

ETFs vs. mutual funds: the bottom line

If you’re looking to diversify your portfolio, both ETFs and mutual funds may be investments worth considering. When you’re getting started as an investor, a fund may provide an accessible entry point, giving you access to a variety of securities with a single investment. And you don’t necessarily have to choose between ETFs vs. mutual funds; you may decide that both have a place in your investing strategy. You can invest in a wide variety of ETFs with Stash, and thanks to fractional shares, you can get started with any dollar amount. 

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• Stocks
• Bonds
• Funds

Stocks and bonds frequently form the building blocks of portfolio and investment strategy. Because they tend to perform differently under different market conditions, investors can use this variance to help meet their investment goals. 

Forms of investment

Here’s an overview of these different types of investments, where and how to invest in them, and the part they can play in your portfolio.

Stocks

Purchasing a stock means buying a small piece of ownership, or a share, in a company. Stocks are bought and sold on stock exchanges. Generally speaking, stock prices rise and fall based on investor demand. Most of the time, the more people want to purchase a particular stock, the higher the price is likely to be. When fewer people want that stock, the price may drop.

You can potentially make money on stocks by selling your shares at a higher price than you paid for them. But stock prices can be volatile, meaning they may rise and fall quickly. Investor demand and stock prices fluctuate for any number of reasons. For example, good news, such as strong sales numbers or the unveiling of a popular new product, could cause stock prices to rise. Bad news, like product safety issues or poor revenue numbers, could cause stock prices to fall.  After prices fall, it can take a while for them to recover. That’s one of the reasons stocks are often held as a long-term form of investment.

Not all successful investment strategies involve holding stocks for long periods, however. More sophisticated investors, such as hedge funds, might use different types of investment strategies designed to generate returns over the short term, such as shorting a stock. Investors using this strategy start by borrowing stocks, then selling them quickly in the hope they can buy them back later at a lower price. If they can, they return the stocks to their original owner and keep the difference in price as profit.

Other sophisticated strategies include using stock options, which are contracts that allow investors to buy or sell a given stock at a set price and time. Options allow investors to bet markets will rise and offer some downside protection. For example, if you buy an option for $20 a share and prices go up to $30, you can use your option to buy shares at the lower price before selling at the higher price. If you buy the same option for $20 per share and stock prices fall, you’re under no obligation to use the option to buy.

You may also get a return on your investment through dividends, which are a share of the company’s profits. Companies typically face a choice between spending their earnings to research and develop new products or distributing them to shareholders as dividends. Many established companies with predictable revenues and expenses choose to divide a portion of their earnings among investors as a regular cash dividend during the year.

Dividends can also make stocks more attractive to investors, as consistent dividend payments are a sign of consistent profits. Since share prices generally rise when stocks become more attractive, dividends can amplify returns in two ways: by paying investors in cash and by increasing stock prices and returns over time.

Bonds

Bonds are interest-bearing securities issued by companies or governments. Investors can purchase them for a set amount of time, known as a bond term. Bonds are a form of debt that the issuer takes out, similar to a loan; in this case, you are “loaning” the issuer money when you purchase the bond. In exchange for this loan, the company or government promises to pay you interest and repay the original amount of the loan when the term is up. Generally speaking, interest is paid regularly in the form of a “coupon.”

Bonds have three basic components: 

• The price at which you buy them
• The interest rate that’s used to calculate your coupon 
• The yield, or return an investor receives between the time they purchase the bond and the end of the loan term 

The interest rate stays the same throughout the life of the bond, while the bond’s price will usually change based on the movement of interest rates in the economy.

Those price changes happen because bonds become more or less attractive to other investors based on a combination of current interest rates and the return another investor could get buying a new bond. When interest rates go down, older bonds that pay higher coupons may become more appealing, which can drive their price up.

The opposite happens when interest rates go up: The price of older bonds that pay lower coupons generally goes down. It’s important to remember that in either case, the interest rate you get paid for holding the bond remains the same.

Stocks vs. bonds: risks and returns 

Over the long term, stocks may offer higher returns than bonds. Since 1926, stocks from large companies have returned an average of 10% per year. For 2020 and going forward, however, the projected compound return for large U.S stocks is forecast to be about 4%. But because stock prices can be volatile, they are usually considered a more risky form of investment than bonds. Unless the bond issuer defaults, you’ll receive a fixed return over the life of the bond, in addition to having your principal repaid. That’s one reason bonds are also called fixed-income investments.

The lower risk associated with bonds often translates into lower long-term returns compared to stocks. Government bonds, which are backed by the United States Treasury, have returned between 5% and 6% since 1926. Bonds issued by private companies, or corporate bonds, range in quality based on the likelihood that their issuer will be able to make timely payments. In most cases, the highest-quality corporate bonds pay more interest than government bonds, even though large, established blue-chip companies are unlikely to default on their payments.

On the other end of the spectrum, companies with a shakier track record and a higher risk of default tend to issue bonds with much higher interest rates. While these so-called junk or high-yield bonds offer investors a better return, the chances that investors actually receive all their payments are substantially lower.

Building a portfolio of stocks and bonds

While you can buy a single stock or bond, many investors choose different types of investment vehicles that help them build a more varied portfolio. This strategy is called diversification: a form of investment that helps investors spread the risk of poor performance among multiple securities. That way, if a particular business or industry runs into trouble, other more successful businesses or industries can help balance out your returns. Investment products such as mutual funds, exchange-traded funds (ETFs), and index funds offer investors opportunities to buy a range of stocks, bonds, or a mix of both. 

Different types of investment vehicles 

Mutual funds

A mutual fund consists of a basket of investments chosen by fund managers. When you buy a share in a mutual fund, you buy a share of the portfolio. Buying a share of the portfolio means you’re buying a fraction of a share from each of the stocks and/or bonds the fund holds. 

Mutual fund prices are determined at the end of the trading day and depend on the total price of all the assets in the fund’s portfolio. At the end of each day, mutual funds calculate their per-share price, or net asset value. The total value of the portfolio is divided by the number of outstanding shares held by investors. That calculation provides the price at which shareholders can buy or sell.

Exchange-traded funds (ETFs)

ETFs are a form of investment similar to mutual funds. Both hold a basket of investments, and owning a share equates to owning a fraction of a share of each of the stocks and/or bonds the fund holds. However, shares of ETFs trade on exchanges all day long, just like individual stocks. As a result, the price of a share in an ETF can fluctuate throughout the day based on stock market demand.

Index funds

The investment professionals who build mutual funds and ETFs usually have a strategy in mind. Often, that means investing in a variety of stocks or bonds with similar traits, such as large companies, small companies, or companies from a certain industry or a particular part of the world. Index funds are a type of mutual fund or ETF that matches the companies making up a major stock or bond index, such as the S&P 500, the Dow Jones Industrial Average, or the Bloomberg Barclays Aggregate Bond Index. These funds aren’t actively managed by investment professionals. Consequently, buying shares of these funds tends to have lower costs than actively managed mutual funds or ETFs.

How to get started with different types of investments

Whether you’re looking to invest in stocks, bonds, or funds, you generally need to open a brokerage account or another specialized account like a 401(k) or an IRA. You can also purchase government bonds online directly from the U.S. Treasury.

Your goals will help you determine the different types of investment options you choose. Brokerage accounts can be good for short-term investment goals, since they provide relatively easy access to your money. Retirement accounts may be advantageous for long-term goals, since they don’t allow easy withdrawals. 

Stash has boiled down its investing philosophy into the Stash Way, which includes leveraging various forms of investment for a diverse portfolio, investing regularly, and investing for the long term.

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One of the best ways to learn about a fund is by reading its prospectus. All stocks, bonds, mutual funds, and ETFs are required by law to file a prospectus with the Securities and Exchange Commission (SEC).

When you read a prospectus, you may see a lot of jargon. Fear not! We’ve broken it down and decoded it so you can be a smarter and more confident investor.

What’s a prospectus?

A prospectus is essentially the  financial blueprint of a stock, bond, or fund. (In this article, we’re talking about funds.) The prospectus can help you familiarize yourself with its holdings and objectives, and provide you with information about its performance, managers and fees.

In the old days, a paper version of the prospectus would have been sent to you in the mail. Today, a fund’s prospectus is easily and readily available online. Most times you can find it by simply typing the fund’s ticker and “prospectus” into a search engine.

But the SEC also maintains a database called EDGAR that includes prospectuses, and that’s fully accessible to the public. The SEC keeps all investment prospectuses updated if you want to explore investments or to keep tabs on changes to a fund.

Generally, there are two kinds of prospectus–the summary, and the long-form. It’s advisable to look at the long-form version, as it contains more information.

One of the best ways to learn about a fund is by reading its prospectus.

Here are the main things to look for:

General information

Fund objective: The name of the fund will almost always tell you what the fund’s goals are. But near the top of any prospectus, you’ll also find a general statement about the fund’s objective: Does it track in an index? Is it going after growth or value? Perhaps it focuses on a particular sector or industry, such as technology, energy, or healthcare. As you build your portfolio of stocks and funds, you want to diversify. This section will help orient you as you develop your own strategy.

Fund managers: The names of the people who established the fund, and who runs it, are typically listed. Many times, funds are passively managed because they follow an index. That means there is no active manager picking stocks. Nevertheless, the prospectus will list either an individual or an investment group that established the fund, or oversees it. This can be valuable information for you to conduct more research, or to get in touch if you want to.

Fees and expenses

It’s critical to pay attention to the fees portion of a prospectus, because it will tell you how much it will cost you each year to own the fund. Say a fund has an annual return of 5%, and the total annual fees are 2%, your actual gain would be 3%. Over time, that can really eat into what the investment returns. Generally speaking, you want to keep your fees as low as possible, and industry guidance will tell you that means less than 1%.

Management fees: The managers of the fund may charge for running it.  Management fees are typically deducted as a fixed percentage annually.

12b-1 fees: These are charged for costs associated with the marketing and promotion of the fund, including the sale of a fund through brokers.

Total annual operating expenses, or expense ratio: This is the most important number to keep track of, because it will tell you what it costs to own the fund each year. Generally speaking you want a fund with an expense ratio less than 1%, and as low as 0.25% for index funds with no active manager.

Load: You may be charged a sales fee when you purchase the fund, which is known as a load. You might also be charged a load for selling the fund. Many funds are known as no-load, meaning you can purchase shares–and sell them–without this fee. You might want to seek these out, because they will save you some money.

Redemption fee: If you sell the fund within a short time frame, you may get hit with this charge. For example, if you sell the fund before six months, you might be charged a redemption fee. It’s to discourage market timing–or buying and selling the fund quickly.

You can find out more about fees here.

Holdings

This section is critical, as it will tell you how many companies the fund invests in, and exactly which ones. If the fund is quite large, the prospectus may not tell you each company the fund holds–although that information is public, and widely available on the fund company’s website, other investment sites, or at SEC.gov–it will often tell you the top ten companies in the portfolio, and the percentage of assets it invests in each of these companies. Different companies are assigned different weights in a fund, and this information can help you figure out whether the fund’s investment strategy aligns with your objectives.

Risks

Just as you want to know how your car will perform in bad weather, at high speeds, or in traffic, you also want to know what possibile liabilities your fund might have. The risks section will help inform you about all of that. If the fund invests in only large companies, for example, it will have different risks than if it only follows much smaller companies. The same thing goes for sector-focused funds, which are a subset of the stock market. Each sector is subject to individual economic factors, events, or possible shocks. For example, new taxes or tariffs could negatively affect some industries. Shortages of raw materials might affect others, or new legislation might have consequences for yet other businesses.

Performance

This segment will tell you about the returns of the fund over a period of years. It will tell you things like the total annual return–which will be expressed as a percentage that the fund’s value either increased or decreased during a particular year. (The numbers in the performance section can be quite detailed, and may involve the return after taxes on distributions, which are a part of the fund’s profits.)

The performance portion will also compare the fund’s returns to a category, such as similar funds, typically called peers, or an index such as the S&P 500 or Russell 5000. If the fund you’ve invested in is performing better or worse, compared to a peer or index, that can be useful information about whether you want to invest in or–if you already have–hold on to the fund.

Good to know: In addition to the prospectus, fund companies produce something called a Statement of Additional Information, or SAI. It will provide you with more detailed financial information about the fund, including performance, taxes and debts, as well as details about fund managers and directors. It’s free, but you must write directly to the fund company in order to get it. The address of the fund company is typically included in the prospectus.

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