Investing can be exciting and confusing, especially for beginners. There are so many securities to choose from, including stocks, bonds, mutual funds and exchange-traded funds (ETFs), and the options available to you are constantly changing.
Rather than sort through endless investment choices, many investors simplify things by turning to mutual funds and ETFs. Both types of funds typically contain a mix of securities, giving you an easy way to diversify your portfolio and spread the risk that comes with putting money into the markets.
While both vehicles can help to diversify your investments, there are differences and similarities between the two that investors should be aware of before they buy. Here, we break down what makes these two types of funds different and the same, and some reasons investors might choose them based on their investing needs and styles:
What are ETFs?
ETFs are a basket of securities, such as stocks, bonds, funds or other assets, that trade on stock exchanges. They offer a way to spread asset risk across various categories, such as sectors (banking, technology, real estate and so on), geographies (Canada, the U.S. or international), or themes such as sustainability and even artificial intelligence (AI). With bond ETFs, the basket can include various types of corporate or government bonds, or both.
Canada is often recognized as having created the first modern-day ETF. It was launched on the Toronto Stock Exchange in March 1990. An updated version of this ETF, the iShares S&P/TSX 60 ETF (XIU), is Canada’s oldest-running and largest ETF. Mutual funds have been around since the 1930s and make up the lion’s share of the fund market, but ETFs have been rapidly growing in popularity since they were created in Canada more than 30 years ago.
ETFs were initially designed to be “passive,” by matching the overall performance of an index such as the S&P 500 or the S&P/TSX Composite Index. In recent years, many “active” ETFs have come to market. They are managed by an investment advisor or team that decides which securities go into the fund.
Benefits of investing in ETFs
ETFs are an increasingly popular way to invest. Here’s a look at some of their upsides.
- Low cost ETFs tend to have lower fees and no minimum investment compared to many mutual funds.
- Easily accessible ETFs can be bought and sold during trading hours on an exchange, which makes them well-suited for both day traders and long-term investors looking to manage their own investments.
- Offer an easy way to diversify You can buy ETFs that cover an entire market or ETFs that cover a specific sector — and just about anything in between. By mixing and matching these ETFs, you can get broad exposure to different parts of the market in a way that you can’t with individual stocks.
- Transparent ETFs also tend to be more transparent, given that issuers provide the full list of underlying holdings on their website.
How to buy ETFs in Canada
ETFs are available to purchase through a financial advisor or a trading platform like TD Direct Investing or TD Easy Trade. Before making any investment decisions, make sure the ETF aligns with your time horizon, investment goals, risk tolerance and investment objectives.
What are mutual funds?
A mutual fund is typically managed by a qualified portfolio manager who decides when to buy, hold or sell the underlying investments contained in the fund — this is referred to as active management. The first open-end mutual fund in Canada launched in 1932, during the Great Depression, enabling people with small amounts of capital to participate in a professionally managed, diversified investment product. 1 Today, there are thousands of mutual funds to choose from.
Benefits of investing in mutual funds
Mutual funds are often well-suited to investors looking for a hands-off way to diversify a portfolio. They are typically designed for long-term investors.
How to buy mutual funds in Canada
There are two main ways for investors to purchase mutual funds: through a financial advisor at their bank or wealth management company, or online through a discount brokerage. Before purchasing, investors should ensure the mutual funds align with their time horizon, investment goals, risk tolerance and investment objectives.
What are the similarities between ETFs and mutual funds?
Mutual funds and ETFs are pooled investments that offer convenience and diversification. Here are the ways in which the funds are similar.
Both mutual funds and ETFs offer investors a chance to diversify their portfolio within one security or unit, which can lower risk. It may also reduce the cost of buying and selling securities.
Mutual funds and ETFs generate income for investors in two similar ways. The first is from capital gains, or the increase in value of the investable assets themselves. The other is from distributions, which can come in the form of regular distribution of dividends, interest or other income from the investments, depending on the fund you choose. By making regular contributions to your investments, you can take advantage of compounding interest to grow your wealth.
Both mutual funds and ETFs can be held in registered accounts, such as a Tax-Free Savings Account (TFSA), a Registered Retirement Savings Plan (RRSP), or in a non-registered accounts. This means they can be held in different accounts and help round out a broader investment portfolio strategy. They can also be tailored to hold a heavier mix of equities and higher-risk securities for more aggressive investors, or a greater mix of lower-risk investments such as bonds and cash for conservative investors. Both types of funds can help investors meet their individual investment goals.
ETFs vs. mutual funds: What’s the difference?
While both mutual funds and ETFs offer an effective way to diversify a portfolio, there are some key differences to be aware of when choosing to invest in one or the other, or both.
Mutual funds and ETFs are bought and sold differently. Investors trade ETFs in real time on an exchange, like stocks, while mutual funds are bought and sold through either a dealer or a stockbroker. The price of a mutual fund unit is calculated once a day, based on prices at market close.
The management expense ratio (MER) — which is the combination of a fund’s management fees and operating expenses — is usually higher for mutual funds compared to ETFs. That’s because mutual funds are actively managed by professionals, while ETFs tend to be more passive, tracking an index, which can make them more cost-efficient. That said, there are more active ETFs on the market today, and that can mean a higher MER.
FAQs: ETFs vs. mutual funds
What are some of the disadvantages of owning an ETF over a mutual fund?
ETFs are praised for their versatility, but there are a few areas where mutual funds have the upper hand. First, because ETFs are traded like stocks, you may incur a trading fee when buying and selling them. Similarly, ETFs may not allow for fractional share purchases, which could mean you may not be able to invest all of your money. In contrast, mutual funds generally don’t charge any fees when you are buying and selling them. And although they may have minimum investment requirements, they’re often quite low (and that requirement can be as little as $25 on subsequent investments once you have established a position in the mutual fund).
Finally, many ETFs are passively managed, meaning there is no portfolio manager looking to change the makeup of the portfolio to capitalize on opportunities and avoid losses. While there are some actively managed ETFs, many are rules-based, meaning they may not have as much flexibility to actively manage their holdings.
Why would I choose an ETF over a mutual fund?
Investors might choose an ETF over a mutual fund if they’re looking for a flexible, low cost and transparent approach to investing. Here are some of the key benefits:
- ETFs trade in real-time, like stocks, which makes them suitable for all types of investors.
- Lower fees are key characteristic of ETFs. In addition, they don’t require minimum investment, making them a low-cost alternative for many portfolios. That said, you still need to be mindful of trading commissions and trading costs that may result from the frequent trading of ETFs, which could potentially eat away at your returns.
- ETFs also tend to be more transparent in their disclosure of holdings, which are usually available on the provider’s website.
What is an AI ETF?
An AI ETF is a fund that focuses on companies potentially benefitting from the rapidly increased adoption of robotics and artificial intelligence in business and society. These companies include everything from industrial robotics and automation firms to companies that support and deploy the technologies.
Are ETFs riskier than mutual funds?
Both ETFs and mutual funds come with risks. Regardless your choice of investment vehicle, making the time to read the investment prospectus of an ETF or mutual fund will help you understand the risks that are relevant to that investment.
Do ETFs pay dividends?
There is a growing selection of ETFs that seek to provide income by investing primarily in, or gaining exposure to, dividend-paying equity securities and other income-producing investments. If this type of ETF is held in a registered account there may be tax considerations.
- “The evolution of mutual funds,” Investment Funds Institute of Canada, https://investorcentre.ific.ca/evolution-mutual-funds/#:~:text=Before%20mutual%20funds%20were%20created,midst%20of%20the%20Great%20Depression. Accessed on Oct. 30, 2023. ↩