- ETFs and mutual funds have important differences.
- Mutual funds are priced once a day based on the value of their holdings, while markets set the price for ETFs throughout the day.
- Active funds and ETFs offer the potential to outperform an index.
- Build a strategy based on your goals, risk tolerance, timeline, and finances, and that can help you choose a type of product.
Today's investors face what seems like an ever-growing variety of investment choices, with new mutual funds and exchange-traded funds (ETFs) continuing to arrive. In recent years, "smart beta" (or "factor") and other actively managed exchange-traded funds have appeared, combining the ETF structure with the potential to outperform an index.1
Trying to make sense of these different products doesn't have to be overwhelming. Here is what to expect, and some factors to consider as you weigh your investment objectives.
A brief history of funds and ETFs
For decades, investors have turned to traditional actively managed, open-ended mutual funds for an easy-to-use product to help them meet their financial goals and offer the potential to outperform a benchmark (often a widely followed index).
In the early 1990s, the set of investment vehicles available to investors expanded with the creation of ETFs. ETFs give investors pricing during the day and more discretion over the timing of their trades. Like stocks, ETFs allow investors to choose their market entry and exit points throughout the trading day, so they might take advantage of market developments in real time.
In 2008, actively managed ETFs came on the scene. In these vehicles, a portfolio manager attempts to outperform an index, versus just replicating an index's performance.
From an investor's perspective, these actively managed ETFs offer a way to combine the potential advantages of active management with the trading flexibility of exchange-traded products.
Different products, different experiences
As you consider ETFs and open-ended mutual funds, it is important to recognize how the vehicles' similarities and differences may influence your investing experience. Buying and selling, pricing, disclosure, costs, holding-period return, and tax implications can all be different (see the table below).
For example, unlike with a traditional open-ended mutual fund, the price of an ETF is set in the open market. Higher demand from investors can result in the shares trading at a premium (compared to the value of the stocks that the ETF holds), and falling demand could cause the ETF to trade at a discount (compared to the value of the ETF's holdings). This continuous pricing and the ability to place limit orders—means the ETF's performance for any given time period is based largely on the market price return during the holding period, rather than on the ETF's net asset value (NAV)—the value of the stocks held by the ETF.
|Comparing ETFs and open-ended mutual funds|
|Exchange-traded funds||Open-ended mutual funds|
|Buying and selling||
|Holding period return||
|† ETFs and mutual funds are subject to management fees and other expenses.|
Which vehicle is right for an investor?
Typically, the best way for an investor to choose an investment is to use his or her own goals, financial situation, risk tolerance, and investment timeline to create a strategy. Using that perspective may help to identify appropriate investment vehicles. Consider the following types of investors and their varied objectives.
Fidelity believes in taking a long-term view of investing. But some people choose to be more active, accepting the risk and costs of buying and selling securities more frequently. If you prefer to manage your own accounts and want to trade during market hours to implement your preferred investment strategies, ETFs can offer the flexibility to meet your needs. Similar to stocks, ETFs can be traded throughout the trading day and on margin. Investors also have the ability to set limit orders and sell short. Most open-ended mutual funds can only be purchased at their closing prices, or NAVs. ETFs offer transparency, allowing investors to review holdings daily and monitor portfolio risk exposures more frequently than with traditional open-ended mutual funds.
In this example, ETFs may satisfy the investor's need for more trading flexibility and holdings transparency.
Consider investors weighing options for their long-term investment goals. Fidelity believes that short-term trading is generally not an appropriate savings strategy. With a long-term view, investors may not want to devote a lot of time to worrying about the intricacies of an active trading strategy; they might have little use for the potential of buying or selling shares during the day; and they would likely want to minimize transaction costs for regular purchases.
Many open-ended mutual funds are available with no loads, no commissions, and no transaction fees. Many brokerages and banks offer automatic investing plans that allow regular purchases of mutual funds. These programs generally do not exist for ETFs. Moreover, open-ended mutual funds are bought and sold at their NAV, so there are no premiums or discounts. While an ETF also has a daily NAV, shares may trade at a premium or discount on the exchange during the day.2 Investors should evaluate the share price of an ETF relative to its indicative NAV.
Finally, any tax benefits that may exist for an ETF are irrelevant for someone saving in an tax-deferred IRA or workplace savings account, such as a 401(k).
In this example, a traditional open-ended mutual fund could be an investor’s preferred option due to low transaction costs and automatic investing options.
Investors in a high tax bracket
Investors in a high tax bracket who are saving in a taxable account, like a brokerage account, may be interested in investments that offer tax efficiency for their taxable assets. In this scenario, if an investor finds that an open-ended index mutual fund and an index ETF are similar relative to his or her investment objectives, passive investments—index funds and passive ETFs—have the potential to be more tax efficient than active funds and active ETFs.
Relative to actively managed mutual funds, some actively managed ETFs offer potential tax advantages.3 However, we caution investors against making long-term investment decisions based solely on any potential tax benefits. Investors should evaluate how an investment option fits with their time horizons, financial circumstances, and tolerance for market volatility, as well as cost and other features.
In this example, the investor may choose ETFs to take advantage of potentially greater tax efficiency.
While mutual funds and ETFs are different, both can offer exposure to a diversified basket of securities, and can be good vehicles to help meet investor objectives. It is important for investors to pick the best choice for their specific investing needs, whether an ETF, an open-ended mutual fund, or a combination of both.
Here are some points to consider when weighing vehicle options:
Is it important to be able to execute fund trades at prevailing prices throughout the trading day? Consider ETFs.
- Transaction costs
Would you prefer trading a fund at NAV without paying a load, and avoiding the potential of paying a premium at purchase (discount at sale)? Consider no-load mutual funds.
Do you like the flexibility of trading on margin? Consider ETFs.4
- Automatic saving
Does your investment strategy include dollar-cost averaging? Consider the automated savings features of mutual funds in brokerage accounts.
Do you want to know a fund’s holdings each day? Consider ETFs.
Make sure to consider all costs and expenses related to any investment vehicle.
Do the benefits of both ETFs and mutual funds have the potential to help meet investment goals? Consider building a portfolio incorporating both types of vehicles to gain exposure to different asset classes.
Next steps to consider
Find investment options for your strategy.
Does your portfolio match your goals?
Learn more about choosing an investment vehicle.