Funds are the kind of investments that just make sense. It’s when investors pool their money together to buy a diverse basket of assets, and divide returns between themselves. It’s a cheap and effective way to get exposure to certain indices, themes, regions, asset classes or sectors. There are two major types of fund available to investors, Exchange Traded Funds (ETFs) and mutual funds.

Many people – mistakenly – believe that ETFs are passive investments, and mutual funds are active. But that’s not exactly accurate. The differences and similarities between these two investment vehicles are much more nuanced. To understand more, it’s helpful to dive into the history of how and why they were created.

Mutual Funds came first

Before the days of funds, investors needed to be very rich to build a diversified portfolio. Most could only afford to buy a couple of shares. In times of recession, like the Wall Street Crash of 1929, this meant they could potentially lose their entire wealth in a single day.

In the 1920s, a handful of mutual funds began to emerge in the USA. Probably inspired by similar products in Europe, these funds pooled together money from many investors and bought many investments. The investments were bought and managed by a fund manager. Sensibly, the group of investors all shared in the profits together, mutually. This is where the name “mutual fund” comes from.

To buy into a mutual fund, investors dealt with the firm directly. They literally bought shares in the mutual fund itself and they couldn’t trade them on the stock market. Investors needed to wait until the markets closed to find out the price they would be paying. This is still true for mutual funds today.

After the 1929 crash, these small funds were among the few left standing. Regulators and institutional investors (like banks or pension funds) began to take notice. But mutual funds didn’t gain widespread popularity among ordinary retail investors until almost fifty years later.

Around the 1980s, mutual funds flew into fashion. Around the world, and especially in the USA, markets became bullish and everyone wanted a piece of the profits. Just ten years previously, William Fouse and John McQuown had created the first ever index fund. This offered people a low cost way of getting excellent diversification by following an index. You could say that index funds were the bridge between mutual funds and ETFs.

In 1990, the first ETF hits the market

Against this sunny 80s backdrop, a new type of “mutual fund” was created. But unlike the traditional version, this one would be available to trade on the market exchange, and at any time of day – just like a share. The “Exchange Traded Fund” was born. The first one emerged in Canada in 1990.

Unlike its predecessor, the Mutual Fund, ETFs were much more like index funds. Rather than being managed by an expensive team of investors, the ETF simply copied – or tracked – other benchmark indices. For example, the first ETF in the USA in 1993 tracked the top 500 US stocks, the S&P 500. This made shares, or divisions of shares, in ETFs unbelievably cheap.

For many investors, ETFs were a welcome addition, as they offered exceptional diversification for the price of a single share.

In 2008, the Securities and Exchange Commission made the approval process for ETFs much easier. This opened the door for actively-managed ETFs. While the majority of ETFs are still passive, around 2% now fall into this category.

Over the subsequent decades, the stock market soared and plunged. But mutual funds and ETFs continued to grow in popularity. At the time of writing, there are around 132,000 mutual funds and 8,500 ETFs.

ETFs are often (but not always) passive

At the start of this article, we explained how most people wrongly believe that ETFs are only passive investments, and Mutual Funds are only active. While this is not absolutely true, in most cases it is a good rule of thumb. This explains why mutual funds generally have higher fees than ETFs.

Since mutual funds are often actively managed by an expert and a team of human analysts, the fees paid by investors need to include their salaries. Fees for mutual funds, therefore, tend to range between 0.5% and 1%. By contrast ETFs simply track the markets and don’t need any expert management, so fees generally fall between 0% and 0.2%.

Because of the extra management and structure, minimum investment thresholds for a mutual fund are often higher too. They usually stretch into thousands of pounds. However, with Plum, you can get access to these managed funds for a fraction of the price.

ETFs are a lot more liquid as well. One of the most defining features – the namesake – of ETFs is that they can be traded on an exchange during the day. Like other shares, they have bid-ask spreads and can be bought or sold from other investors instantly.

Conversely, with mutual funds you’ll need to wait until the markets have closed to find out how much you can buy or sell your mutual fund shares for. The cost is known as the Net Asset Value or “NAV”. It’s calculated by subtracting the liabilities from the asset value and dividing by the number of shares outstanding… A bit more complex!

As an investor, you should consider how important liquidity is for you and your needs. If you may need to convert your investments into cash within the same day, ETFs may be a better option than mutual funds.

Different levels of transparency

As ETFs generally track an index, and can be traded instantly, they are quite straightforward. Investors can easily see what they are buying into and how much it will cost. By contrast, mutual funds are less transparent.

Mutual funds are often actively managed, and the holdings are not always as easy to view. The structure is more complicated too and can vary from fund to fund.

ETFs can be traded like shares  

Because an ETF share is traded like a stock, investors can do more things with it. For example, it’s possible to short – bet against –  an ETF share. It’s also possible to arrange other derivatives, for example, investors can buy options, puts, spots, forwards with ETF shares.

However, unless you’re a professional trader, it’s probably best to avoid derivatives as you build your portfolio. They can be extremely risky.

Which one is better?

Both ETFs and Mutual Funds have different pros and cons. ETFs are generally cheaper, more liquid and more transparent, but they don’t have experienced managers overseeing them. You will never beat the market with passive investing, so most ETF holders should manage their expectations.

With mutual funds, there is the chance that they could beat the market. There’s also a wider variety of mutual funds available – more than 15 times the choice of ETFs. As well as the vast range of management styles and high quality service.

In the end, the best type of fund for you comes down to your unique situation. Whatever you opt for, be sure to research your investments carefully, and don’t take risks you feel uncomfortable with.

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Please remember that, as with all investing, your capital is at risk. You shouldn’t invest in or deal in any financial product unless you fully understand it and the inherent risks.

The information contained in this article is for general guidance only and is not intended to constitute investment advice or any other advice or recommendation. Remember, investing carries a risk and the value of your investments can go down as well as up.