Mutual funds vs. ETFs

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.

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 an investor weighs their objectives.

Different products, different experiences

While considering ETFs and open-ended mutual funds, it is important to recognize how the vehicles' similarities and differences may influence an investor's 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 throughout the day. 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.

Which vehicle is right for an investor?

Typically, the best way for an investor to choose an investment is to use their 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.

Active investor

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 an investor prefers to manage their own accounts and wants to trade during market hours to implement their preferred investment strategies, ETFs can offer the flexibility to meet their needs. Similar to stocks and other types of investments, 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.

For the active investor, ETFs may satisfy the investor's need for more trading flexibility and holdings transparency.

Long-term investor

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 a tax-deferred IRA or workplace savings account, such as a 401(k), since taxes are paid upon withdrawal.

For the long-term investor, both ETFs and open-ended mutual funds could be appropriate choices based on investment goals.

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 their 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.

Investors in a high tax bracket may choose ETFs to take advantage of potentially greater tax efficiency.

Summary

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:

• Trading Is it important to be able to execute fund trades at prevailing prices throughout the trading day? Consider ETFs.
• Transaction costs Would an investor prefer trading a fund at NAV without paying a load, and avoiding the potential of paying a premium at purchase (discount at sale)? Consider ETFs or no-load mutual funds.
• Margin Does an investor like the flexibility of trading on margin? Consider ETFs.⁴
• Automatic saving Does the investor's strategy include dollar-cost averaging? Consider the automated savings features of mutual funds in brokerage accounts.
• Transparency Does an investor want to know a fund’s holdings each day? Consider ETFs that offer holdings transparency.
• Cost Make sure to consider all costs and expenses related to any investment vehicle.
• Diversification 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, including other types of investments, to gain exposure to different asset classes.