Isn't freedom great? If you've held a company-sponsored 401(k) or 403(b), you know that your company gave you a false sense of freedom. They said that you were "free" to pick from any one of the handful of mutual funds that they picked for you. Picking from their choices doesn't seem like much freedom, but maybe you took the extra step and opened an IRA.

Now that's freedom. With IRAs opened outside of your company, you have the choice of just about any investment option on the market. Ninety-four billion dollars is invested in self-directed IRA accounts, where many people choose to exercise the freedom of this retirement account and put their money into stocks and bonds themselves instead of using mutual funds. However, freedom also comes with responsibility and risks. Your choices have increased from around a dozen to thousands. You might be thinking that you'll stick with funds instead of individual stocks and bonds, and that's a wise choice, especially if you're new at investing. However, what kind of funds should you choose? Mutual funds or exchange-traded funds (ETFs)?

SEE: Mutual Funds Vs. ETFs

The Difference
Mutual funds come in two main varieties: actively and passively managed funds. Actively managed funds employ a team of presumably expert managers who buy and sell investment products on behalf of the fund in an attempt to do better than the market as a whole. Passively managed funds employ a low-paid team of computers to track an index and are designed to mirror the market.

ETFs, like a passively managed mutual fund, attempt to track an index, often by the use of computers, and are also intended to mimic the market. For example, say you have an ETF such as the SPDR S&P 500 and the S&P 500 goes down. If that happens, then your ETF's value will also drop.

Mutual funds and ETFs have many differences under the hood, but most of them aren't of much concern to you if you're just getting started as an investor. However, you should understand a few of these differences.

The Exchange
Mutual funds are bought and sold at their NAV or net asset value, which is calculated at the end of the day. ETFs trade just like stocks. You can buy and sell shares at any time during the day at the current price, which changes very rapidly. You can purchase one share of an ETF or millions, but they must be full shares. Mutual funds may let you purchase fractions of one share and allow you to purchase as many shares as you would like. However, mutual funds often have high minimum investments if you're trying to manage your own IRA.

SEE: Pursuing Alpha In A Well-Diversified IRA

No Load
There are so many mutual funds on the market now that paying load fees of any type are often ill-advised and unnecessary. A load is a fee you pay to either buy or sell a stake in a mutual fund. These loads often go to the financial advisor who sold you the fund. There are plenty of no load mutual funds on the market but there are no ETFs with load fees. Instead, you pay another type of fee to purchase an ETF.

SEE: The Lowdown On No-Load Mutual Funds

When you buy and sell a stock or ETF, you have to pay a commission to your broker. For most, this is a flat fee regardless of how many shares you buy or sell. Although it's important to take these fees into account, the more shares of an ETF you purchase, the less the commission matters, since it becomes a smaller percentage of the trade.

The Expense Ratio
Both mutual funds and ETFs have expense ratios - the amount of money for the management of the fund. Often, ETFs routinely have lower expense ratios than actively managed mutual funds and they may be in line with passively managed index mutual funds.

The Bottom Line
Because most actively managed mutual funds will fail to beat the market over a long period of time, paying the extra fees in loads and expense ratios may not be money well spent. Instead, consider passively managed mutual funds or ETFs. Both might have a place in your portfolio but because of the ease of buying and selling, and possibly more favorable tax treatment, many IRA investors are finding that ETFs better fit their goals and objectives than mutual funds.

Related Articles
  1. Retirement

    What to Do When Your Doctor Doesn't Take Medicare

    Stay and pay the full fee? Cut and run to another provider? Five ways to cope when Medicare threatens to break up you and your medico.
  2. Mutual Funds & ETFs

    Mutual Funds Are Not FDIC Insured: Here Is Why

    Find out why mutual funds are not insured by the FDIC, including why the FDIC was created and how to minimize your risk with educated mutual fund investments.
  3. Professionals

    How to Sell Mutual Funds to Your Clients

    Learn about the various talking points you should cover when discussing mutual funds with clients and how explaining their benefits can help you close the sale.
  4. Retirement

    4 Reasons Why Americans Retire in Costa Rica

    Understand why more and more Americans are deciding to retire in developing countries. Learn about the top five reasons why Americans retire to Costa Rica.
  5. Retirement

    4 Reasons Why Americans Retire in Mexico

    Learn why Mexico's low cost of living, inexpensive health care, natural beauty and culture make it such a popular retirement destination for Americans.
  6. Retirement

    The Cities Where the Ultra-Rich Retire in Florida

    Understand why the Florida communities of Miami Beach, Palm Beach and Key West serve as magnets for the ultra-rich retirees who descend on the state.
  7. Mutual Funds & ETFs

    Top Three Transportation ETFs

    These three transportation funds attract the majority of sector volume.
  8. Professionals

    Is Delaying Social Security Until 70 a Good Idea?

    Soon to be retirees are often told it's best to wait until age 70 to collect Social Security. Here's why this is not always the best advice.
  9. Professionals

    Tax Efficient Strategies for Mutual Funds

    Before you sell mutual fund shares, consider these tax strategies first.
  10. Professionals

    Fund and ETF Strategies for Volatile Markets

    Looking for short-term fixes in reaction to market volatility? Here are a few strategies — and their downsides.
  1. Can I borrow from my annuity to put a down payment on a house?

    You can borrow from your annuity to put a down payment on a house, but be prepared to pay an assortment of fees and penalties. ... Read Full Answer >>
  2. Can mutual funds invest in hedge funds?

    Mutual funds are legally allowed to invest in hedge funds. However, hedge funds and mutual funds have striking differences ... Read Full Answer >>
  3. What are the main kinds of annuities?

    There are two broad categories of annuity: fixed and variable. These categories refer to the manner in which the investment ... Read Full Answer >>
  4. What are the risks of rolling my 401(k) into an annuity?

    Though the appeal of having guaranteed income after retirement is undeniable, there are actually a number of risks to consider ... Read Full Answer >>
  5. How do I get out of my annuity and transfer to a new one?

    If you decide your current annuity is not for you, there is nothing stopping you from transferring your investment to a new ... Read Full Answer >>
  6. Are Cafeteria plans exempt from Social Security?

    Typically, qualified benefits offered through cafeteria plans are exempt from Social Security taxes. However, certain types ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  2. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  3. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
  4. Operating Cost

    Expenses associated with the maintenance and administration of a business on a day-to-day basis.
  5. Cost Of Funds

    The interest rate paid by financial institutions for the funds that they deploy in their business. The cost of funds is one ...
  6. Cost Accounting

    A type of accounting process that aims to capture a company's costs of production by assessing the input costs of each step ...
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!