ETFs and mutual funds are the two most popular types of investment funds.
They are commonly used by both regular investors and large institutions and are considered a great way to have a diversified portfolio.
Holding a diversified fund is considered less risky than holding individual stocks, and many of these funds have excellent long-term returns.
As both ETFs and mutual funds are "funds," what they have in common is that they pool money together from many investors and hold collections of different assets.
But even though ETFs and mutual funds are similar in many ways, there are also some key differences.
ETF vs. mutual fund: key differences
The main difference between an ETF and a mutual fund is the way it is managed.
An ETF, or exchange-traded fund, is usually a passively managed fund that tracks a market index. It can be traded on a stock exchange, just like a stock.
Mutual funds are usually managed actively, with a fund manager who regularly buys and sells assets within the fund.
You can trade an ETF at any time during market hours, but you can only buy or sell a mutual fund investment at the end of the trading day.
Even though ETFs are usually passively managed and mutual funds usually actively managed, there are exceptions to this. You can also buy actively managed ETFs and passively managed index mutual funds.
The term index fund can apply to both an ETF and a mutual fund. An index fund simply means that it is a fund that tracks an index of stocks, bonds, or other assets. For example, index funds that track the S&P500 stock index are very popular.
This table summarizes the most important differences between an ETF and a mutual fund:
|Management||Usually passive||Usually active|
|Trading hours||Market hours||At market close|
|Expense ratios||Low to medium||Low to high|
|Ticker symbol length||2–4 letters||5 letters|
|Minimum investment||Low (1 share)||Medium to high|
|Limit and stop orders||Yes||No|
|Investment units||Shares||Dollar amounts|
|Passive index fund||Usually||Sometimes|
In many cases, ETFs and mutual funds are provided by the same companies. The top players include Vanguard, Blackrock, State Street Global Advisors, and Fidelity.
Sometimes, these companies will provide basically the same fund as either an ETF or mutual fund.
For example, Vanguard provides an ETF with the symbol VTI and a mutual fund with the symbol VTSAX. Both are "total stock market" index funds that have a similar expense ratio and hold the same stocks.
The main difference for a long-term investor is that the minimum investment is higher in the mutual fund and it can only be bought or sold at market close.
ETFs have lower expense ratios, but mutual funds are often commission-free
The main cost of both ETFs and mutual funds is the expense ratio. This is a percentage of the net assets in the fund that is deducted from it each year.
ETFs tend to have significantly lower expense ratios than mutual funds, which is largely due to the costs of having active managers controlling the investments in the mutual fund.
However, passively managed index mutual funds tend to have very low expense ratios, just like passive ETFs.
On the other hand, mutual fund investors often save on commissions because they can buy them commission-free from the mutual fund provider.
But many brokers now also offer commission-free trading on ETFs, so this is no longer a distinct advantage for mutual funds.
ETFs may have tax advantages
An ETF is considered to be more tax-efficient than a mutual fund.
Mutual funds need to buy and sell assets regularly, which creates capital gains that are then distributed to investors once per year.
However, ETFs usually don't buy and sell their assets in the same way as mutual funds, so there are much fewer taxable events occurring in an ETF.
If you make a profit from an ETF, then you only pay a capital gains tax when that profit is realized — either when you sell the shares for a profit or receive a dividend payment.
But if you own a mutual fund, then you will receive a capital gains payment at the end of each year and need to pay a capital gains tax.
That being said, if you are investing in a tax-advantaged retirement account like a 401(k) or IRA, then the tax efficiency of the two types of funds is very similar.
Does one have better performance than the other?
There is no inherent performance difference between an ETF and a mutual fund.
Some funds get really excellent returns over time, while others lose money. It simply depends on the performance of the fund's assets or trading strategies.
For example, a fund that tracks short-term treasury bonds will have stable but low long-term returns. A fund that tracks tech stocks will likely have better long-term returns, but with much greater risk and volatility.
You can even buy funds that invest in more complicated financial products, like leveraged short selling or volatility indexes. Some of these will lose 100% of their value over time.
So, it is impossible to say whether an ETF or mutual fund is better for performance. It all depends on the individual fund and what it invests in.
However, given that ETFs usually have lower expense ratios and are more tax-efficient, this may give them a minor edge when it comes to long-term performance.
Benefits of choosing an ETF
Mutual funds used to be very popular among investors and institutions. They are still bigger than ETFs if measured as total assets under management.
However, ETFs have been gaining market share in recent years. It is predicted that they will eventually become bigger than mutual funds because of their various advantages.
Here are some benefits of choosing an ETF instead of a mutual fund:
- Lower expenses — ETFs tend to have a lower expense ratio, sometimes as low as 0.03%. That's only $0.30 per year for every $1,000 invested.
- Transparency — Most ETFs disclose their holdings every single day, so you know exactly what you are investing in. Mutual funds are only legally obligated to disclose their holdings each quarter.
- Tax efficiency — ETFs tend to be more tax-efficient than mutual funds, which gives them a slight advantage for investment returns.
- Trading flexibility — It is much more flexible to buy and sell ETFs. You can trade them during market hours, sell them short and even trade options on them.
- Low minimum investment — ETFs tend to have a much lower minimum investment than their mutual fund counterparts.
- Exposure — You can get exposure to all kinds of niche markets and geographies with ETFs. The investing landscape is more limited with mutual funds.
Benefits of choosing a mutual fund
Even though ETFs are generally considered better, investing in mutual funds also has some advantages:
- Dollar investing — You can buy a fixed dollar amount of a mutual fund and get partial shares in the fund. This is not always possible with an ETF.
- Automation — It is often easier to automate your deposits, withdrawals, and dividend reinvestments in a mutual fund.
- Net asset value — The mutual fund always trades at net asset value, while you could lose a bit of money from the bid-ask spread on an ETF.
- Restrictions — Mutual funds only trading once per day can be a benefit for some people. If you are prone to impulsive decisions, then a mutual fund may make it easier to stick to your investment plan.
- Commissions — Many mutual funds can be bought commission-free, which is not always the case with ETFs. This depends on where you are buying the mutual fund from, some brokerages or banks may charge a substantial fee.
- Active management — In some cases, a mutual fund will be run by an incredibly effective manager that beats the market over the long-term. However, this is the exception rather than the rule.
If you are a long-term passive investor doing your investing in a tax-advantaged account, most of the advantages of an ETF disappear.
In that case, it may suit you better to set up an automated investing plan with a low-cost index mutual fund provider like Vanguard.
Index funds are great for beginners
It is often recommended for beginner investors to invest in index funds instead of spending time on stock picking.
In fact, simply buying and holding the S&P500 stock index has historically provided better returns than over 90% of professionally managed investment funds.
Even Warren Buffett recommends that regular investors do this instead of trying to beat the market by picking stocks.
Index funds can be found as either ETFs or mutual funds and both types are considered to be smart long-term investments.
Which is better, an ETF or a mutual fund?
ETFs do have some benefits over mutual funds, such as lower minimum investment requirements and greater trading flexibility. In many cases, they even provide better returns when accounting for expenses and taxes.
So, if you are undecided about which one to invest in and don't have a particular reason to choose a mutual fund, then you should probably pick the ETF.