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You don't need to be a rocket scientist to understand the difference between mutual funds and ETFs

CNBC logo CNBC 8/13/2020 Jill Cornfield
a person sitting at a table © Provided by CNBC

You probably already know that investing in a single, individual stock has risk.

Instead, an easy way to spread out your risk is to invest in a mutual fund — a collection of securities. The funds usually hold stocks, and sometimes bonds. They're professionally managed by a portfolio manager, so they come with fees.

You probably also know what an index fund is: a variation of a mutual fund that holds a basket of stocks that tries to mirror or track the performance of a market index. The best-known indexes are the S&P 500 and the Dow Jones Industrial Average.

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Then there's the exchange-traded fund. U.S. investors have invested more than $4 trillion in ETFs, which have gained greatly in popularity since the Great Recession. 

Here's what to know about this type of fund.  

ETF basics

An ETF is a cousin, if not a sibling, of mutual funds and index funds, says Kip Meadows, CEO and founder of Nottingham, a Rocky Mount, North Carolina, fund administration firm. An ETF's composition — a diversified collection of securities — is similar to that of a mutual fund.

But this type of fund has a few differences, and some features that may make it especially good for a new investor.

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The main difference between these funds and mutual funds is that ETFs trade on an exchange all day, just like an individual stock. In other words, you can buy shares of an ETF in the morning and sell it the same afternoon, says Eric Ervin, CEO of Blockforce Capital, an asset manager based in San Diego.

Investments are always somewhat complicated. There's a lot of under-the-hood construction and regulation you don't see unless you really go looking for it. But you don't need to. You don't have to build Big Ben when you just want to know the time, Meadows says.

The first ETFs were based on an index. These days, you'll see a wide variety, some based on different countries and different sectors, such as oil and energy or technology. That's helpful if you have specific views on how you'd like to invest your money, Ervin says.

ETFs generally don't issue annual capital gains distributions, according to Crystal Stranger, president of 1st Tax, a tax advisory firm — that's a win, come tax time. You will pay taxes on any gains when you sell, however.

One downside is you might be limited to large-cap stocks in some sectors or foreign stocks. That lack of exposure to mid- and small-cap companies could mean missing out on some growth opportunities as an ETF investor.

Buy anytime

Mutual fund prices fluctuate throughout the day, but you can only buy them at the close of business. Say you want to buy a mutual fund comprised of tech stocks such as Apple. At 10 in the morning, you see that the price is pretty good. But you will have to wait till the market closes to buy it, and it can be tricky to nail down the price you want.

An ETF, in contrast, trades throughout the day. Like the price that morning? You can buy it right away, which is great for instant-gratification types.

You know all the ingredients

Mutual funds must post their holdings every quarter, and they can rebalance and change their composition frequently, without letting you know every single movement. Not so with ETFs.

"The day that change is made, you know the next day," Ervin said. "We know every single day what the holdings in that ETF are."

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Where to find these

If you're mainly investing through a workplace retirement plan, such as a 401(k), you may not find any ETFs available.

If you don't have the option of choosing an ETF, don't worry. "Both ETFs and mutual funds have a lot of value," Meadows said. "Our economy is focused on innovation, and more innovation will take place in ETFs over the next 10 years to 15 years."

As more 401(k) participants ask for ETFs and employers start putting them into workplace plans, Meadows says you will probably find them more available.

Meanwhile, they are a good choice for an individual retirement account, whether traditional or Roth.

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