There are many ways to invest in the stock market without buying individual stocks or bonds. Exchange-traded funds (ETFs) and mutual funds are among the most common ways to do this. Both options work well for this type of investment, and many investors use both. However, there are some important differences to keep in mind.
Similarities Between ETFs and Mutual Funds
Exchange-traded funds are quite similar to regular mutual funds in that when you buy a share of an exchange-traded fund, each share represents a small slice of all the underlying investments of the fund, allowing you to diversify your investment across a pre-determined set of stocks or bonds by owning just one fund.
Most exchange-traded funds work similarly to index funds. For example, let’s say you buy an S&P 500 ETF; this fund will own all 500 stocks in the S&P 500 index. It won’t trade in those stocks, it will simply own them. By buying a share of the fund, your money is instantly diversified across all the underlying stocks.
However, exchange-traded funds differ from regular mutual funds in how they are priced and traded, which means you can apply some trading strategies with an exchange-traded fund that you cannot apply with a regular mutual fund.
Pricing of Mutual Funds and ETFs
Regular mutual funds set their price once a day after the market closes. The actual price at which they trade is unknown because orders are submitted during or before market close and then “filled” at the nearest new market value. The closing value will be repriced based on the number of shares bought and sold and the total net asset value of the fund.
The price of an exchange-traded fund works just like stocks, with fluctuations in pennies throughout the trading period. Because the prices of exchange-traded funds change throughout the day, you can buy or sell them in the middle of the day, buy them when the market dips, or sell them when the market rises. Since stock market prices are affected by current news and global opinions, prices are subject to sudden and frequent changes.
One advantage of exchange-traded funds over regular mutual funds is that they typically have lower operating expenses, meaning you pay less to own the fund. Because the investor is actively involved in trading exchange-traded funds, most of them are managed passively, which means management fees are lower. However, you will still pay commissions.
Trading Mutual Funds and ETFs
When buying or selling shares of a regular mutual fund, you buy or sell them directly from the investment company that issues them, so you cannot trade them in the middle of the day, and you cannot use trading strategies like limit orders or market orders. You will buy shares of mutual funds in dollar amounts, meaning you could end up with an uneven number of shares, including fractions. When selling a mutual fund, you will be selling in shares, not in dollars.
On the other hand, exchange-traded funds trade like stocks, where they are priced throughout the day. When you buy or sell them, you are trading them with other investors who are buying or selling. Because an exchange-traded fund trades this way, you can use trading strategies like limit orders or stop orders, which allow you to set a specific price or threshold you want a trade to occur at. Because exchange-traded funds trade like stocks, you will always buy or sell in shares, not in dollars.
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Are Exchange-Traded Funds Good for Retirement?
Although mutual funds are a popular option for retirement investing, fewer investors know about using exchange-traded funds for this purpose. If you are building a portfolio of index funds, the exchange-traded version of the fund will be just fine.
Exchange-traded funds can also be used to target specific sectors of the market or particular industries you want to increase your exposure to. However, for your retirement investment, avoid leveraged exchange-traded funds, which aim to perform at a rate that is two to four times that of the comparative index fund. These funds can cause rapid gains or catastrophic losses, all within a short period of time – which is not ideal for a retirement fund.
Conclusion
Exchange-traded funds and mutual funds can both be great options for retirement investing or other investment purposes. The best choice for you will largely depend on how actively you trade stocks and how much money you think it’s reasonable to pay fund managers to oversee your portfolio. Talk to an investment advisor for more information to help you decide between the two.
Source: https://www.thebalancemoney.com/differences-between-etf-s-and-open-ended-mutual-funds-2388639
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