Investment Vs Mutual Funds: What's The Difference?

Investment funds and mutual funds are both a supply of capital belonging to multiple investors, used to collectively purchase securities. However, there are some key differences between the two.

Mutual funds are an older type of fund that are actively managed, meaning they try to beat their benchmark. They often charge higher expenses than other types of funds, such as exchange-traded funds (ETFs), and may include sales commissions. Mutual funds also typically have minimum initial purchase requirements and can only be purchased after the market closes when their net asset value (NAV) is calculated.

ETFs, on the other hand, are a newer type of fund that are usually passively managed. This means their holdings track a preset index of securities, rather than being picked by a portfolio manager. ETFs generally have lower expenses and no sales commissions. They are also more flexible, as they can be purchased throughout the trading day and there is usually no minimum initial purchase requirement.

Actively managed vs passively managed funds

Actively managed funds and passively managed funds are two different approaches to investing. They are not limited to mutual funds but can also be applied to other types of investments, such as exchange-traded funds (ETFs).

Actively managed funds involve fund managers who take a hands-on approach by actively picking and choosing investments based on their expectations of how those securities will perform. They aim to beat the market's average returns and take advantage of short-term price fluctuations. This strategy requires a deeper analysis and expertise to know when to enter or exit a particular investment. It also involves higher costs due to transaction fees and the salaries of the analyst team.

On the other hand, passively managed funds are designed to mirror the performance of an index by holding the same or similar securities in the same proportions. For example, a passively managed fund might contain all the stocks in a particular index like the S&P 500. When the index rises or falls, the passive fund does too, and it buys and sells the same stocks when the index makes changes. This approach is simpler and more straightforward, with little to no human decision-making involved. It also tends to have lower expense ratios since there are fewer costs associated with analysis and portfolio management.

Both approaches have their advantages and disadvantages. Active management offers more flexibility and the potential for higher returns but comes with higher fees and the risk of underperforming the market. Passive management, on the other hand, tends to be more cost-effective and historically has earned more money, but it may be too limited for some investors as it is locked into a specific index or set of investments.

When deciding between actively and passively managed funds, it is essential to consider factors such as investment goals, risk tolerance, and the level of involvement desired in the investment process. Some investors may even choose to blend the two strategies to take advantage of the strengths of both.

Investment fees and costs

Annual Fund Operating Expenses

These are ongoing fees that cover the cost of paying fund managers, accountants, legal fees, marketing, and so on. They are typically between 0.25% and 1% of your investment in the fund per year and are detailed in a fund's prospectus, a legal document that each fund is required to file with the SEC.

Annual fund operating expenses include:

• Management fees: The cost of paying fund managers and investment advisors.
• 12b-1 fees: Fees capped at 1% that cover the cost of marketing and selling the fund, as well as shareholder services.
• Other expenses: These may include custodial, legal, accounting, transfer agent expenses, and other administrative costs.

Shareholder Fees

Shareholder fees are sales commissions and other one-time costs incurred when buying or selling mutual fund shares. They include:

• Sales loads: Commissions paid to third-party brokers when buying or selling shares, calculated as a percentage of the amount invested. A fee paid at the time of purchase is a "front-end load", while a fee paid at the time of sale is a "back-end load".
• Redemption fee: Charged if you sell shares within a short period of buying them.
• Exchange fee: Charged by some funds if you exchange shares for another fund offered by the same investment company.
• Account fee: Charged to maintain your account, often if your balance falls below a specified minimum.
• Purchase fee: Paid to the fund at the time of purchase, distinct from a front-end sales load.

It's important to note that even if a mutual fund doesn't charge sales loads, it may still charge redemption, exchange, account, and purchase fees.

Tax implications

When it comes to taxes, there are some key differences between investment funds and mutual funds. While both are taxed on dividends and capital gains distributions, as well as gains from market transactions, the way these taxes are applied can vary.

Taxation of Dividends

Mutual funds distribute income generated by the sale of assets, as well as dividend distributions when underlying assets pay earnings or interest. These dividends are typically taxed as ordinary income. However, if the dividend is considered a "qualified dividend" by the IRS, it may be subject to the lower capital gains tax rate. To be qualified, the dividend must be paid by a stock issued by a US or qualified foreign corporation, and the mutual fund must have held the stock for more than 60 days within a specific time frame.

On the other hand, ETFs may have different tax implications for dividends. If an investor has held an ETF for more than 60 days before a dividend is issued, the dividend is typically considered a "qualified dividend" and taxed at a lower rate. If the ETF has been held for less than 60 days, the dividend income is taxed at the investor's ordinary income tax rate.

Capital Gains Taxes

Capital gains taxes also differ between investment funds and mutual funds. Mutual funds that create a lot of short-term capital gains are taxed at ordinary income rates, which can be higher than capital gains tax rates. In contrast, ETFs generally have fewer capital gains distributions, as they use "creation units" to buy and sell assets, minimising taxable events for investors.

Additionally, mutual fund managers actively buy and sell securities, leading to higher portfolio turnover and potentially more taxable events. On the other hand, most ETFs are passively managed, resulting in fewer transactions and lower taxes.

Tax-Exempt Investments

It's important to note that certain types of investments, such as Treasury and municipal securities, may be tax-exempt. Additionally, investments held in retirement accounts typically have tax advantages, regardless of whether they are mutual funds or ETFs.

Trading flexibility

Mutual funds are not traded freely on the open market like stocks and ETFs. They can be purchased directly from the financial company that manages the fund, or through an online discount brokerage or a full-service broker. Mutual funds are traded only once per day, after the markets close at 4 pm ET. If you enter a trade to buy or sell shares of a mutual fund, your trade will be executed at the next available net asset value (NAV), which is calculated after the market closes and typically posted by 6 pm ET. This price may be higher or lower than the previous day's closing NAV.

ETFs, on the other hand, can be traded throughout the day, offering more liquidity, flexibility, and real-time pricing. They can be bought and sold just like stocks, and their prices fluctuate continuously throughout the day.

Mutual funds typically require a minimum initial investment, often between $1,000 and $10,000, though some are higher and some funds set no minimum. ETFs, however, can cost far less for an entry position—as little as the cost of one share plus fees or commissions.

Mutual funds are usually actively managed, meaning fund managers make decisions about how to allocate assets to beat the market and help investors profit. ETFs are usually passively managed, tracking market indexes or specific sector indexes. Actively managed funds tend to have higher fees and expense ratios due to their higher operations and trading costs.

Mutual funds may also carry a range of fees and charges, including sales loads, short-term redemption fees, transaction fees, purchase fees, exchange fees, and account fees. ETFs do not carry sales charges, but some brokerage companies may charge a commission to buy and sell.

Investment minimums

Mutual funds are a popular investment vehicle, especially for retirement accounts like 401(k)s. They are a relatively hands-off way to invest in many different assets at once. Mutual funds are also highly liquid, meaning they are easy to buy or sell.

Mutual funds are either closed-end or open-end funds. Closed-end funds issue a set number of shares through an IPO and trade on the open market, so they are not subject to minimum investment amounts. Open-end funds, on the other hand, do enforce a minimum investment, which typically ranges from $1,000 to $5,000. However, this minimum may be lowered or waived if the investment is made in a retirement account or if the investor agrees to automatic, recurring investments.

Many mutual funds require minimum investments to ensure sufficient capitalization and cover operating costs. While some funds have minimums of $500 to $5,000, institutional-class funds and hedge funds may require minimums of $100,000 or more.

Some mutual funds have no minimum investment requirements, meaning even a small amount of money can get you invested. For example, Vanguard offers several mutual funds with $0 minimums, while Charles Schwab offers a broad market index fund and target-date funds with no minimum initial purchase. Fidelity offers mutual funds that can be bought for as little as $1.

When deciding how much to invest, it's important to consider your budget and how much money you have to comfortably invest. It's also worth noting that mutual funds can carry different fees, such as expense ratios and front- and back-end "sales loads", which can eat into your returns over time.

Frequently asked questions