We’ve already examined some of the key decisions every investor has to make when building a portfolio – from how much risk they take on to their mix of shares and bonds and the extent to which they invest globally. Having also looked at index versus active funds, we now turn to another ‘which type of fund’ question: exchange-traded funds (ETFs) or mutual funds?
Vanguard offers both types. Although the differences between them isn’t huge, it’s important to know what they are before choosing.
The term ‘mutual fund’ here is used as an umbrella term to cover a range of pooled investments, including open-ended investment companies (OEICs) and unit trusts.
These have been around in the UK for decades and they work by pooling the money from like-minded investors and investing it at scale. All the investors in any given fund get a slice of the same portfolio. The fund provider then calculates a fund price once a day and trades at that price1.
In this way, mutual funds allow individual investors to benefit from economies of scale, chiefly in the form of lower costs and greater diversification than they might otherwise be able to achieve on their own.
Because of that, mutual funds are highly regulated. Companies that offer them must abide by strict rules about how they describe a fund’s benefits and risks, what it can invest in, and how they report their results.
What’s more, money in a mutual fund is ring-fenced from the fund provider’s balance sheet, which means it’s not vulnerable if the fund provider gets into financial difficulty.
ETFs share many of the same characteristics. They combine investors’ money to bring scale and cost benefits. Most are highly regulated too and any investor money is again ring-fenced from the fund provider’s own assets.
But the key difference is in the way investors buy and sell ETFs. Unlike with mutual funds, where it is the fund provider who prices the fund and creates or redeems fund units to meet client demand, ETFs trade like shares on stock exchanges. It is literally why ETFs stand for ‘exchange-traded funds’.
What that means is that investors buy and sell them through an investment platform or broker who will often charge a fee for this service. This is an extra potential cost that investors need to factor in when considering whether to invest in an ETF.
It’s not the only additional cost. Because ETFs trade like individual shares there’s usually a difference between the buying price and the selling price at any one moment. This slight difference is known as the ‘bid-ask spread’ and it’s a bit like the difference between the ‘we buy at’ and ‘we sell at’ spreads you might see when buying foreign currency for your holiday – but nowhere near as wide!
So, as well as changing in price throughout the trading day like shares do, the buying price for an ETF will always be slightly different to the selling price at any one given point.
Of course, the advantage ETFs have over mutual funds is the added flexibility they provide the investor. Because they trade like shares, it is possible to buy or sell an ETF investment in real-time and know the price you traded at more quickly.
At Vanguard, we also give you two choices when it comes to ETF investing: trade at a ‘live’ price and pay £7.50 commission each time or take advantage of our twice-a-day bulk trading service and pay no commission by opting for the ‘next available price’.
How do you choose between ETFs and mutual funds?
At Vanguard we believe there are far more similarities between ETFs and mutual funds than there are differences. As such, we believe that your strategy should drive your structure – that is, deciding what you want to invest in and over what timeframe should shape your choice of fund.
In that respect, these practical considerations could help:
- What do I want to invest in? Is that available as a mutual fund and/or an ETF? And what are the respective costs of those funds?
- How frequently do I need to trade? The once-a-day pricing frequency of mutual funds is perfectly adequate for long-term, disciplined investors. But if you need access to intra-day prices, you are likely to favour ETFs. Beware investment platform fees though.
- Active or index? At Vanguard, we offer both active and index exposure through ETFs and mutual funds. At an industry level, most ETFs pursue an index investing strategy.
- Can I invest in both types? Of course you can – you can easily combine both types of fund in your portfolio.
Whichever option you choose, though, remember that the value of your investments can rise or fall and you might get back less than you invested.
In part six, we look at why your costs matter so much to your investment success.
1 At Vanguard, all our UK and Irish domiciled mutual fund range operate a partial swing pricing model. This means we take into account a fund’s net cash flows when setting our daily prices.
Investment risk information
The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.
Past performance is not a reliable indicator of future results.
Other important information
This article is designed for use by, and is directed only at persons resident in the UK.
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