ETFs vs. Mutual Funds: Key Differences to Consider

ETFs and mutual funds are both securities that represent a diverse basket of assets. However, they also each have their own unique benefits.

• Exchange-traded funds (ETFs) and mutual funds are both securities that represent a mixed basket of other assets, such as stocks, bonds, etc.
• While both types of investments offer diversification and professional portfolio management, they also each have unique characteristics, such as fees, when they trade, tax efficiency, etc.
• Consider the differences between these two types of securities and how one might be more advantageous over the other in your portfolio.

In the world of investing, mutual funds and ETFs are two very popular types of securities that may help you become better diversified and seek to utilize investment strategies used by professional portfolio managers.

While each has its own unique benefits and characteristics, the difference between an ETF and a mutual fund might not be as much as you might think. Here's what you'll want to know and how they might help you achieve your financial objectives.

What Is a Mutual Fund?

A mutual fund is an investment representing a pooled group of assets. These often include diverse combinations of various stocks, bonds, commodities, and even other mutual funds.

Mutual funds rely on capital from thousands of investors to purchase assets and pay for administrative costs, such as the fund manager and portfolio maintenance. As the name suggests, investors who purchase shares of these funds "mutually” benefit from the performance of the underlying assets they hold.

Types of Mutual Funds

There are several varieties of mutual funds for investors to choose from:

• Equity Funds - Equity funds focus on stocks. They are generally characterized by their market capitalization (large-cap, medium-cap, or small-cap) and investment prospects (growth vs value).
• Fixed Income Funds - Fixed income funds invest in long, medium, and short-term debt instruments such as bonds, government securities, and treasury bills.
• Money Market Funds - Money market funds invest in short-term debt such as treasury bills, certificates of deposit, and commercial paper.
• Asset Allocation Funds - Asset allocation funds combine multiple types of securities to achieve specific investment goals.
• Target Date Funds - Target date funds are intended to prepare their shareholders for retirement by gradually adjusting their asset allocation over time.
• Index Funds - Index funds aim to replicate the performance of a major benchmark such as the S&P 500 or NASDAQ.
• Sector-Specific Funds - Sector-specific funds invest in specific types of companies, organizations, or causes.

What Is an ETF?

An ETF is a security representing a collection of various assets such as stocks, bonds, and other investments. Just like a mutual fund, it offers a practical way for investors to diversify across several different types of assets and utilize advanced investment strategies.

Despite their similarities, ETFs were designed to be traded in open exchanges (just like stocks). This makes them unique compared to mutual funds in terms of who can use them, potential tax efficiency, and reporting transparency.

Types of ETFs

Like mutual funds, there are many ETF categories for investors to utilize:

• Index ETFs - The majority of ETFs are index-based, meaning that they mirror major market benchmarks for asset classes such as large-cap stocks or U.S. Treasury bonds.
• Sector ETFs - Sector ETFs target specific types of businesses or markets such as energy, technology, healthcare, precious metals, etc.
• Synthetic ETFs - Synthetic ETFs invest in financial derivatives such as options, futures, swaps, etc.

Similarities Between ETFs and Mutual Funds

Both ETFs and mutual funds have many desirable traits that could be appropriate depending on your investment objectives and risk tolerance. The following are a few common benefits.

Investment Options

Whether you're interested in large-cap stocks, corporate bonds, or even alternatives like gold and real estate, there's likely an ETF or mutual fund that will fit this niche. Many of these securities specialize in one specific sector or investment strategy, so there are often plenty of options that meet your preferences for risk and reward.

Diversification

Since both ETFs and mutual funds represent a mixed basket of assets, a handful of selections is typically all that is necessary to achieve adequate diversification across a variety of different businesses and sectors. For example, interest from all 500 companies in the S&P 500 benchmark may be purchased using a single index ETF or mutual fund.

Professional Fund Management

ETFs and mutual funds both give investors the chance to work with professional fund managers. Rather than picking individual stocks and bonds on their own, investors may buy shares of ETFs or mutual funds and benefit from the investment strategy and decision-making that the manager has chosen to utilize for that fund.

Automatic Reinvestment

Distributions from both mutual funds and ETFs may easily be used to purchase additional shares. This is a commonly used strategy called a dividend reinvestment program (DRIP) that helps investors compound their portfolio growth.^[[1]

Key Differences: ETF vs Mutual Fund

While ETFs and mutual funds might share some common characteristics, it's important to remember that each type has its own unique features. The following are a few important distinctions.

Comparison Table:

Trading and Pricing

The way that ETFs and mutual funds are valued and traded is a major fundamental difference between these two types of securities.

Mutual fund net asset value (NAV) is calculated once per day after the markets close. ^[2] Therefore, while orders to buy and sell mutual funds may be placed at any time, they are not fulfilled until the end of the business day after information about their assets can be reported.

ETFs also have an inherent NAV based on the investments they hold. However, because these securities are free to trade in the open market during normal business hours, the share price may sometimes be more or less than the NAV based on the current market conditions.

Management Style

Although mutual funds and ETFs come in both active and passive varieties, the majority of mutual funds tend to be actively managed while ETFs tend to be passive in nature. This means most mutual funds tend to have a portfolio manager making decisions about which assets to hold, while the passive ones are simply mirroring an established benchmark.

Costs and Fees

Because ETFs tend to be more passively managed, they generally have lower expense ratios than mutual funds. An expense ratio is the annual cost of owning the fund expressed as a percentage of the fund's average net assets. Because ETFs trade like stocks, they might also be subject to commissions if your brokerage charges them.

Tax Efficiency

In many circumstances, ETFs tend to be more tax-efficient than mutual funds due to the way distributions are made. Because mutual fund NAV is recalculated once per day, capital gains and dividends are usually returned to the shareholder and count as taxable income unless the funds are held in a tax-sheltered retirement account like an IRA or 401(k).

Many ETFs also pay their shareholders dividends, which count as taxable income. However, capital gains are not typically returned to the shareholders and are instead realized once the ETF shares are sold.

Inception

ETFs are relatively new products in the investing industry when compared to mutual funds. The first mutual fund, the Massachusetts Investors Trust (MIT), began in 1924.^[3]Meanwhile, ETFs weren’t created until 1990, with the first one debuting in the U.S. in 1993.^[4]

Transparency and Holdings Disclosure

ETFs typically offer greater transparency over mutual funds. This is because ETFs are required to disclose their full portfolio holdings daily, while mutual funds need only publish their holdings monthly or even quarterly.

How To Choose: ETF vs Mutual Fund

Both ETFs and mutual funds are commonly used to help diversify a portfolio. Yet, some features may make one more suitable than the other for certain situations. Consider the following:

• Not all retirement accounts allow participants to trade securities such as ETFs, individual stocks, etc. Particularly with workplace retirement plans, such as a 401(k), you may only be limited to choosing from a pre-selected list of mutual funds.
• For non-retirement brokerage accounts, ETFs may be better suited for tax efficiency purposes. Because many ETFs don’t return capital to their shareholders, this could simplify the tax reporting process and potentially result in a lower tax bill.
• Investors who prefer to trade more frequently or who use financial platforms where mutual funds are not available may find ETFs to be a more convenient option.
• Because many ETFs aren’t as established as mutual funds, their performance record may only be a few years or even months. Investors who rely on this information when selecting funds may find some comparable mutual funds to be a better fit.  

Frequently Asked Questions (FAQ)

Can I own both ETFs and mutual funds in my portfolio?

Yes. However, this may depend on your financial service provider. Most brokerages allow investors to trade ETFs. However, not all offer mutual funds. Those that do generally offer a limited selection.

Are all ETFs cheaper than all mutual funds?

Not necessarily. Although ETFs, on average, may generally be cheaper than mutual funds, there are many cases where some mutual funds may cost less. This should be evaluated on a case-by-case basis.

Are ETFs or mutual funds better for retirement accounts?

Both ETFs and mutual funds are well-suited for retirement accounts. Your ability to use one or the other will depend on your financial service provider and investment preferences. In circumstances where you can choose either, consider how fees and investment performance may play a role.  

Final Thoughts

Both ETFs and mutual funds are great tools to enhance your portfolio and utilize the strategies used by professional fund managers. However, features such as being able to trade in the open market and better tax efficiency may make one type more advantageous over the other.

Investors should understand the pros and cons of both and consider how each could meet their needs. Always consult a financial professional for personalized advice and guidance.