We frequently get questions about exchange-traded funds (ETFs), specifically “What are they?” and “How are they different from mutual funds?”
To help explain, let’s head back to the swimming pool given how effective a prior pool analogy was when we compared different investment approaches.
If you can picture a swimming pool, you’re already on your way to understanding how both ETFs and mutual funds actually work. Like swimming pools, ETFs and mutual funds are structures or containers. While pool walls are designed to hold water (obvious, we know!), ETFs and mutual funds are designed to hold stocks and bonds in a single container. That container is a fund you can buy.
ETFs and mutual funds are both great for individual investors wanting to save and invest for the future. Let’s say you’ve got $1,000 to put to work for you. Investing in individual stocks and/or bonds with that amount wouldn’t allow you to build a globally diversified portfolio, especially once you tack on trading costs. But ETFs and mutual funds pool the money of many investors together to buy a variety of investments. Owning an ETF or mutual fund effectively allows you to hold the underlying stocks and bonds in the “pool” proportional to your investment.
So how are they different?
There are a few technical differences. An ETF can offer more trading flexibility since it trades on an exchange throughout the day, with prices fluctuating continuously. Mutual funds, on the other hand, are only priced at the end of a trading day, so trades entered during a market session would be executed at a price calculated after market close. ETFs only trade in whole units (just like a stock), while mutual funds have partial units. ETFs also don’t have investment minimums, whereas many traditional mutual funds do.
Ultimately, ETFs and mutual funds are more similar than different. And most importantly, both can help you reach your investment goals.