ETFs, or exchange-traded funds, and mutual funds have a lot in common.
Both investment products pool investors' money into a collection of assets — typically stocks, but can be other assets like bonds, real estate, and commodities. Geared towards individuals, both offer a low-cost, diversified way to invest.
But ETFs and mutual funds also hold important differences, especially in the way they're traded and managed, and what they charge and how they're taxed.
What is a mutual fund?
A mutual fund is a group of assets like stocks or bonds that you can purchase by pooling money with other investors. They are run by a professional portfolio manager who selects the fund based on a published investing strategy, so all the investors (and regulatory bodies like the SEC) know what they're getting when they invest.
As of 2019, there are nearly 8,000 US-based mutual funds with total assets worth a staggering $21.3 trillion, according to Statista.
Mutual funds offer plenty of benefits, from their affordability to the fact that professionals do the research for you. They also help diversify risk: You buy a fund with many different assets to avoid getting burned if any individual asset loses its value. Mutual funds are intended to be long-term, buy-and-hold investments.
What is an ETF?
Like a mutual fund, an ETF is an investment vehicle that combines money from many investors into a pool to invest in stocks, bonds, and other assets.
Developed in the mid-'90s, ETFs are younger than mutual funds, but their number has exploded over the last 10 years. As of 2019, there are over 2,000 ETFs based in the US, with approximately $3.4 trillion in assets.
Unlike mutual funds, however, ETFs trade daily on stock exchanges — which means that they can be turned over early and often, though they are also suited to a long-term investment strategy.
If the aim of mutual funds is to beat the market, the aim of ETFs is often to follow the market. The majority of ETFs are index funds, meaning their portfolios mirror the holdings of a particular segment of the stock, bond, or commodity markets, be it a general one like the S&P 500, or a highly specific one, like biotech.
The main differences between ETFs and mutual funds
The diversification that ETFs offer makes them very similar to mutual funds. But when figuring out which is right for you, there are a few key differences worth knowing.
1. ETFs and mutual funds are sold differently
If you have a brokerage account, either at a traditional full-priced broker, a discount broker, or an online trading app, you can buy and sell ETFs. You may have to pay broker fees per transaction, which can add up if you're buying small quantities often.
In contrast, you buy a mutual fund either through a brokerage or through the investment company that owns and manages it. Time was when these investment companies wouldn't offer funds from other firms, only their own (does a Nike store sell Reeboks?). But over the last 10 years, as they've evolved into "financial services providers," some of the larger players — think Vanguard or Fidelity — have started offering other fund families, too.
2. ETFs and mutual funds are priced differently
Mutual funds set their prices only once a day after the markets have closed. The price of a mutual fund share is technically known as the net asset value (NAV) since it represents the combined worth of the entire portfolio, not just a particular holding.
ETF share prices are like any stock share price: continually changing throughout the day, based on buying and selling in the market. So they can be more volatile than mutual funds.
3. Mutual funds are actively managed, while ETFs are typically passively managed
For the last couple of decades, mutual funds have offered active money management: financial pros — fund managers, backed by analysts — who pick and choose investments, trying to deliver market-beating returns. And ETFs have been the vehicle of choice for passive, auto-pilot investing — following an index or other group of assets, on the grounds that nothing outperforms the market overall.
Recently that dichotomy has changed somewhat: You can find many actively managed ETFs, and if you want passively managed mutual funds, you can find those too.
However, ETFs remain the darlings of robo-advisers and automated trading platforms. If you have an online investment account, like one from Betterment, Merrill Edge, or Vanguard Digital Advisor, odds are it's investing your money in index ETFs.
4. ETFs are cheaper than mutual funds
Mutual funds are generally more expensive than ETFs. They require more human power to operate, which means they charge larger fees to pay their managers and commissions to pay salespeople.
While they're spending less money on marketing than they have in the past, many funds still charge sales commissions called "loads." Other fees include redemption fees, exchange fees, account fees, and management fees.
For example, in regards to equity mutual funds, the average expense ratio — as these fees are collectively called — is 1.24%, according to the Investment Company Institute (ICI). All these fees add up and cut into the total return of the fund.
With ETFs the only commission you pay is to your broker, and since 2018 many brokers have waived transaction fees and commissions.
Because they're so often passively managed, ETFs generally have lower expense ratios, as low as 0.03% The average is 0.49%, according to the ICI.
5. Mutual funds have higher minimums
Mutual funds generally demand a minimum investment, ranging from a few hundred dollars to four — or even five figures.
With ETFs, there is no minimum investment, and the price is whatever a single share costs on the exchange at that time.
6. ETFs have tax advantages
ETFs are a little more tax-friendly than mutual funds, which also brings down the total cost of owning them. When a mutual fund manager sells an asset for a profit, the holders of the fund are liable for a portion of the capital gain on that sale, even if they still own the fund itself.
Because the buying and selling that regulates the price of the ETF is done by outside parties ("authorized participants" in investment lingo) and not the fund itself, holders of ETF shares are not liable for capital gains unless they personally sell their shares at a profit.
7. Retirement plans prefer mutual funds
When you have an employer-sponsored 401(k) or a 403(b) plan account, you're restricted to the funds offered by the plan manager. Those offerings overwhelmingly remain mutual funds.
Although they technically can offer ETFs, many plans shy away from them due to compliance issues: Actively traded ETFs can come perilously close to being considered speculative investments, which are frowned on for retirement accounts. This is particularly true of 403(b) plans, which have more strict rules about what kinds of investments they can make.
8. You can unload ETFs faster
Mutual funds being priced only once a day, at the end of the day, makes it hard to get your money out quickly — because you see the price of its underlying assets falling, for example.
In contrast, you can sell an ETF any time during the trading day, like any stock. Of course, because they're so easy to buy and sell, you could be more likely to make a bad, emotionally driven move.
The financial takeaway
While they're both geared to individual investors, ETFs have become popular since the turn of the 21st century as a low-cost alternative to mutual funds. ETFs charge lower fees and have no minimum investment (other than the price of a single share).
Still, outnumbering ETFs as they do, mutual funds offer more variety, and a chance to outperform the market.
For investors who are saving for retirement, especially in an employee-sponsored 401(k) plan, mutual funds may be the best investment. For DIY investors, especially those who prefer to operate via an app or online, ETFs may offer the edge.