ETFs vs Mutual Funds: Key Differences You Should Know

If you’re looking for diversification in your investment portfolio, both ETFs and mutual funds can be appealing options, but how do they compare? 

ETFs, or exchange-traded funds, are funds composed of securities traded on an exchange throughout the trading day. Mutual funds are bought directly from investment companies instead of exchanged between investors. Mutual funds have greater total assets due to their presence in retirement plans like 401(k)s and IRAs, but ETFs have grown quickly in the last decade, and both have the potential to help your investment objectives.

This article will compare the differences and similarities of ETFs and mutual funds to help you decide which is the best investment vehicle for your financial goals. 

What Is an ETF?

An ETF, or exchange-traded fund, is a fund that invests in a basket of securities, such as a stocks and bonds. ETFs typically track the performance of a market index making them relatively low risk and low cost, due to their passive design. So, when you invest in an ETF, you are essentially buying a share of the fund.

There are many types of ETFs, but the most popular include stock ETFs, commodity ETFs, bond ETFs, international ETFs, and sector ETFs.

1. Stock ETFs: Stock, or equity ETFs, track major stock market indexes such as Nasdaq or the S&P 500 Index. This type of ETF gives your portfolio exposure to many different stocks with a single purchase, but are riskier than either bonds or commodities. 
2. Commodity ETFs: A commodity ETF tracks specific commodities, or raw materials like gold or oil. Investors purchase a derivative contract that follows the price of the commodity. Read more, here.
3. Bond ETFs: Bond ETFs give investors access to the bond market, but with the ease of stock trading instead of using a bond broker. On the stock market, bonds are more liquid because they aren't subject to maturity dates.
4. Inverse ETFs: Inverse ETFs, also called short or bear ETFs, capitalizes on a stock or investment declining in price. The ETF bets on the direction of a stock using futures contracts, explained further here.
5. Sector ETFs: A sector ETF is a pooled investment vehicle that invests in the stocks and securities of one particular industry sector, such as technology or energy. They have high liquidity and are often used by investors for hedging or speculating. 

👉 To learn more about ETFs, read: Everything You Should Know About ETFs

What Is a Mutual Fund?

A mutual fund is a fund that pools investors' money into a diversified portfolio of securities, so that you, the investor, can own a share of the fund. Mutual funds are typically actively managed but can also be passively managed.

Most mutual funds are in one of four categories: money market funds, bond funds, stock funds, and target date funds. 

1. Money market funds: Money market funds can only invest in high-quality, short-term investments issued by U.S. corporations and governments, and are generally low risk. 
2. Bond funds: Bond funds invest in bonds (governmental, municipal, corporate, or convertible), and other debt instruments. They produce higher returns than money market funds, but are slightly risker. 
3. Stock funds: Stock funds invest in corporate stock, and have many sub-types. Income funds pay regular dividends, while growth funds are stocks without a regular dividend but high potential for financial gain. Index funds track a particular market index, while sector funds specialize within a specific industry.
4. Target date funds: Target date funds hold a mixture of stocks, bonds, and other investments. These are long-term investments designed for individuals planning for retirement or other long-term commitments. 

What Are the Similarities Between ETFs and Mutual Funds?

The appeal of both mutual funds and exchange-traded funds is that they offer instant, low-cost diversification to your investment portfolio.

Buy into one fund

Both ETFs and mutual funds allow investors to engage in the stock market by buying into one diversified fund rather than investing in individual securities to create a diversified portfolio.

You can also invest in the same types of assets using both, including traditional assets like stocks and bonds as well as precious metals and commodities.

Same regulations

Both exchange-traded funds and mutual funds adhere to the same regulations when it comes to what they can own, how much can be concentrated in their holdings, and how much money they can borrow. 

Open-ended

ETFs and mutual funds are both open-ended, meaning that you can buy and sell shares continuously without restrictions on the amount. 

What Are the Differences Between ETFs and Mutual Funds?

While ETFs and mutual funds serve similar purposes, they have a few key differences that can help you decide which will work best for your investment objectives.

Type of fund management

Mutual funds typically have active management, while ETFs typically have passive management. 

Using active management, a fund’s manager chooses which stocks to buy and sell and when to do so: they are always trying to beat their benchmark. With passive management, a fund manager follows an index that has already been selected instead of selecting stocks themselves. The S&P 500 index or the Nasdaq 100 may be used, as they are the most popular. 

Passive management usually gives ETFs a slight advantage over mutual funds, because it is difficult for active fund managers to beat the market and surpass their benchmark. In 2019, CNBC reported that active fund managers trailed the S&P 500 Index for the ninth year in a row. Although the best funds can beat their benchmarks, it is unlikely they will do better than an index.

Fund expense ratios

The expense ratio of a fund shows how much investors pay each year as a percentage of the amount invested to own a fund.

ETFs tend to be less expensive, particularly when they are passively managed. Some have expense ratios as low as 0.03%, which means investors pay only 30 cents each year for every $1,000 they invest.

While both ETFs and mutual funds can be index-tracking, index-tracking ETFs have lower expenses than index-tracking mutual funds. This is because ETF providers want the price of an ETF to align closely with the net asset value (NAV) of the index, so they adjust the supply of shares by creating new shares or redeeming old shares.

Brokerage and sales commissions

Most brokerage accounts, including Fidelity and Vanguard, have cut commissions to zero on all of their ETF offerings. Investors do not have to pay any fees to trade ETFs, which is a big advantage especially for those who use dollar-cost averaging as an investment strategy.

Mutual funds might charge sales commissions, but many do not, so you can avoid these fees when possible. When you do invest in mutual funds with sales commissions, they usually take one to two percent, but it can be more. Many brokerages will also charge a fee for trading mutual funds, some at up to $50 per trade, though more companies including Fidelity have launched zero-fee funds.

Minimum investment

When purchasing an exchange-traded fund, brokerages tend to require you to buy at least one share of a fund to make a purchase. However, with an increase in fractional shares being offered, that can also be avoided. 

Mutual funds often require you to purchase at least $1,000 to open an individual account, and can also charge early redemption fees. 

When they can be traded

ETFs are purchased during the trading day, while the pricing of mutual funds requires them to be priced only at the end of each trading day. Although you can place your order during the day, it will not be filled until the mutual fund is tallied up when the market closes and the trading day ends. Although you always pay the exact net asset value (NAV) of the fund’s holdings, you do not know the pricing until the transaction is complete. 

ETFs are easier to trade, as they are traded like a stock on an exchange, and you know exactly what the price will be. You also may pay more or less than the fund’s NAV. This flexibility gives ETFs an edge over mutual funds.

Tax efficiency

Mutual funds and ETFs differ in how they pay out investors; mutual funds typically pay distributions at the end of the year, while ETFs pay dividends throughout the course of the year. 

ETFs can pay cash dividends on a quarterly basis, so the more ETF shares you own, the higher your total payout will be. This isn’t the case with all ETFs, as fixed-income ETFs pay out interest. 

When it comes to tax implications, ETF distributions are either considered qualified or non-qualified:

• Qualified dividends: Qualified dividends are paid on stock held by the ETF, and the ETF shares must be owned for more than 60 days during a 121 day period. This period begins 60 days before the ex-dividend date, and is taxed at the capital gains tax rates. 
• Non-qualified dividends: Non-qualified dividends are taxed at ordinary income tax rates, so they do not offer the same advantages. 

Mutual funds are required to distribute their capital gains at the end of the year. If you receive a cash payout at year’s end, you will then have to pay taxes on it to the IRS. However, if your mutual funds are held in tax-advantaged accounts like your IRA, you can avoid this complication.

Mutual funds incur a higher capital gains tax, especially because they are bought and sold more frequently than ETFs, The capital gains taxes apply to everyone with shares in the fund, even if you have not sold your shares yet. ETFs are only taxable once you sell shares.

ETF vs. Mutual Funds: Which Is Right for You?

The good news is that both ETFs and mutual funds have similar risk, which can be high or low; it depends on the fund itself. Investors must pay attention to the characteristics of individual stocks and funds, not just the type of fund or asset. The performance of an ETF and a mutual fund on the S&P 500 index or the Nasdaq 100 will perform similarly. 

ETFs have the advantage over mutual funds when it comes to fees, commissions, and other extraneous costs, along with being more tax-efficient. However, in specific circumstances including stock index funds, mutual funds can be cheaper than ETFs.

Because mutual funds are more established, investors who have been in the game for longer are more likely to hold mutual funds with taxable gains, and selling those funds may trigger the capital gains taxes. It may be more beneficial to hold onto the mutual fund instead of moving to an ETF.

For new investors, however, ETFs are typically easier to use, as they are more accessible and come with lower costs. Talk to your portfolio manager or financial advisor about the best option for you, especially if your goal is a diversified portfolio: both investment options can be useful tools depending on your investment strategy.