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- ETFs (exchange-traded funds) and mutual funds offer cost-efficient ways to diversify, but they differ in how they’re taxed, traded, and managed.
- ETFs are typically passively managed and trade like stocks, with lower fees and minimums than mutual funds.
- Mutual funds are professionally managed investment portfolios that trade once a day and are preferred by 401(k) plans.
Exchange-traded funds (ETFs) and mutual funds are investment vehicles that pool investors’ money into a collection of assets such as stocks, bonds, real estate, and commodities.
Either type of fund can be an easy, cost-effective method of diversifying a portfolio across and within multiple market sectors. Investing in ETFs and mutual funds is less risky than investing in individual stocks or bonds. Professional portfolio managers oversee the funds, which are often designed to track a market index.
However, ETFs and mutual funds are traded and managed differently, with varying fees and tax implications.
ETFs vs. 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.
What are ETFs?
An ETF is an investment vehicle that combines money from multiple investors into a blended pool of stocks, bonds, and other assets. Most ETFs are index funds aimed at following the market by mirroring the holdings of a particular market segment like the S&P 500.
ETFs were developed in the mid-1990s but have become increasingly popular over the last decade. There are 3,457 in the US as of March 2024, reaching just over $8.87 trillion in assets.
You can trade ETFs daily on stock exchanges, which means they can be turned over early and often. However, ETFs are generally best for long-term investment goals.
What are mutual funds?
A mutual fund is a group of assets, like stocks or bonds, that can be purchased by pooling money from various investors. Professional portfolio managers select 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.
US investors have consistently had around 8,000 mutual funds available over the last two decades, with approximately $26.38 trillion in money managed as of February 2024. This is slightly less than the $23.9 trillion in 2020 but a significant increase compared to 2010, which held around $11.82 trillion in assets.
Mutual funds aim to outperform the market and are best used as long-term, buy-and-hold investments.
Key differences between ETFs and mutual funds
“As an investor, you must ask yourself: Do I want the opportunity mutual funds offer to perform differently from the market but pay more for it,” says Liz Young, head of investment strategy at SoFi. “Or do I want the exposure to the market at large offered through ETFs at a cheaper price?”
Here are the key differences between ETFs and mutual funds.
Trading and liquidity
Anyone with a brokerage account can buy and sell an ETF through a traditional, full-priced broker, discount broker, or online trading app. You may have to pay broker fees per transaction, which can add up over time. However, some of the best online brokerages offer commission-free trades of ETFs and other assets.
Like stocks, ETFs are priced throughout the trading day. This makes them easy to buy and sell, resulting in higher liquidity than mutual funds that are only priced once a day at the end of the day.
Mutual funds can be bought through a brokerage or the investment company that owns and manages the fund. Moreover, some larger players — think Vanguard or Fidelity — have evolved into “financial service providers by offering other fund families.
Also, mutual funds usually have higher minimum investments, ranging from a few hundred dollars to four — or even five figures. ETFs don’t have minimums, and the price is whatever a single share costs on the exchange at that time.
Management style
ETFs are often passively managed as they follow an index or other group of assets. This makes them the darlings of many of the best robo-advisors like Betterment or Vanguard Digital Advisor. Mutual funds, however, typically offer active money management from financial professionals like fund managers who pick and choose investments in an attempt to deliver market-beating returns.
But recently, this dichotomy has changed somewhat: Over the last few years, finding actively managed ETFs and passively managed mutual funds has become easier.
Check out Business Insider’s guide to passive vs active investing strategies >>
Costs and fees
Like stock share prices, ETF share prices continuously change daily based on trading market volume. This makes ETFs more volatile than mutual funds.
On the other hand, mutual fund prices are only set once per day after the markets have closed. The price of a mutual fund (aka the net asset value or NAV) represents the combined worth of the entire investment portfolio, not just a particular holding.
Mutual funds are generally more expensive than ETFs as they require human attention. You’ll pay more on managers and commissions to salespeople. Mutual funds may charge “loads,” which are sales commissions. Other fees to consider are redemption, exchange, account, and management fees. For example, regarding equity mutual funds, the average expense ratio is 0.42% in 2023, according to the Investment Company Institute (ICI).
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, averaging around 0.15% in 2023.
“Make sure you do your research and compare fees on ETFs,” Young says. “There are a number of ETFs that track the S&P 500 and have roughly the same performance and stocks in them. So, make sure that you’re not paying extra for an ETF that’s exactly the same as a cheaper one.”
Tax efficiency
ETFs are slightly more tax-friendly compared with mutual funds. With ETFs, holders are not liable for capital gains because the buying and selling that regulates the price of ETFs is done by outside parties (“authorized participants” in investment lingo). However, holders will be liable if they sell their shares at a profit, at which point, tax rates are determined by how long they’ve held their shares.
With mutual funds, the fund holders are liable for a portion of the capital gains from the sale when a mutual fund manager sells an asset for a profit. This is still the case even if the holders own the fund.
Pros and cons of ETFs
Although ETFs offer a straightforward, low-cost way to diversify your portfolio, one of the main disadvantages of investing in ETFs is the volatility.
“You won’t have the opportunity to perform better than the market with a passively managed ETF,” says Young. “If the broader market experienced a sharp decline, you’re ETF will also experience a sharp decline. With ETFs, it’s important to ensure that you provide the right kind of diversification in other parts of your portfolio to prevent being overwhelmed by market swings.”
Pros and cons of mutual funds
One of the biggest advantages of mutual funds is the potential for higher returns by outperforming the market. However, a significant disadvantage is that there is no guarantee that it will.
You may also be subject to capital gains distributions. “The fund manager makes changes throughout the year and as a holder, you are then subject to the taxes of those changes,” says Young. “You have less control from a tax perspective with mutual funds.”
Which is better for you: ETF or mutual fund?
While both ETFs and mutual funds are geared toward individual investors, ETFs have increased in popularity as a low-cost alternative to more costly mutual funds. Generally, ETFs charge lower fees and have no minimum investment requirement, making them ideal for fee-conscious investors and beginners.
Still, mutual funds offer more variety and a chance to outperform the market. Mutual funds may be the best investment for investors who are saving for retirement, especially in an employee-sponsored 401(k) plan. However, you’ll be restricted to the funds the plan manager offers.
“When you buy an ETF or mutual fund, part of your homework is keeping track of why you bought it,” says Young. “In two or five years, revisit why you bought it and try not to emotionally react and sell it. Determine if the thesis is still intact. If the thesis has been broken, it’s time to reevaluate.”
When choosing between investing in ETFs and mutual funds, consider your investment strategy and risk tolerance. If you’re having trouble getting started, consult a CFP for expert guidance and advice.
ETF vs mutual funds — Frequently asked questions (FAQs)
The main difference between ETFs and mutual funds is how they are traded and managed, which affects liquidity, pricing, and investment strategies. ETFs are typically passively managed funds traded on stock exchanges like individual stocks. ETF prices fluctuate throughout the trading day, increasing their volatility. On the other hand, mutual funds are actively managed and are bought and sold at the fund’s net asset value (NAV), which is calculated at the end of the trading day.
ETFs are generally more cost-effective than mutual funds as ETFs often have lower expense ratios and lack commission fees. Also, ETFs are traded on stock exchanges, so investors can take advantage of market fluctuations when buying and selling ETFs. That said, you should research and compare ETFs, as not all funds are built the same.
Both ETFs and mutual funds are suitable for long-term investment strategies. An ETF or mutual fund may be a better fit depending on your goals, risk tolerance, and preferred management style. For example, ETFs are cost-effective, passively managed funds that aim to mirror the market. In comparison, mutual funds are actively managed funds that tend to be more costly but can yield higher returns. Mutual funds are more common in retirement plans, like 401(k)s and 403(b)s.
ETFs are generally more tax-efficient than mutual funds because ETF transactions tend to minimize capital gains distributions by exchanging vs. selling. Mutual funds distribute more capital gains through frequent buying and selling of assets within the fund, leading to potentially higher tax liabilities.
Yes, investing in both ETFs and mutual funds is a common strategy to increase portfolio diversification through broader market exposure. By investing in both ETFs and mutual funds, you can leverage the advantage of each and create a well-rounded investment portfolio.
