What’s the Difference Between ETFs and Mutual Funds?

ETFs and mutual funds are often mentioned simultaneously, as though they’re two versions of what is basically the same investment vehicle. While it’s true they do have many similarities, there are enough differences to make them unique funds. And because of those differences, each will serve you as an investor in very different ways.

ETFs require no minimum investment, can be acquired commission-free, and generate little in the way of taxable short-term capital gains, and won’t underperform the market. However, mutual funds do have minimum initial investment requirements, often generate short-term capital gains, and have the potential to outperform the market – but may also underperform it.

When you become familiar with the differences between ETFs and mutual funds it makes properly allocating them in your portfolio easier. You may ultimately decide to become an ETF investor, a mutual fund investor, or even choose to invest in both.

ETFs vs Mutual Funds – How They’re Similar

The major similarity between ETFs (exchange traded funds) and mutual funds is that they’re both investment funds. That is, each is a portfolio of securities in multiple companies, whether through stocks, bonds, or other investment vehicles. Each can contain securities of anywhere from a few companies to hundreds or even thousands. That means an investment in either type of fund will give you a ready-made portfolio of investments in many different companies.

Each fund also has an investment manager overseeing the portfolio, who may make changes in the portfolio makeup either occasionally or frequently. And both have certain fees associated with them to compensate the investment manager and to cover investment related expenses.

One of the attractions of both ETFs and mutual funds is that they offer investors an opportunity to invest in a portfolio of professionally managed securities. That avoids the need to create your own portfolio, which will require not only selecting which companies to invest in but also the important decisions of when to buy and when to sell each security.

There’s yet another similarity between ETFs and mutual funds that’s often misunderstood by investors – both ETFs and mutual funds can be either actively managed funds or index funds.

An actively managed fund is one in which the fund manager attempts to outperform the market. This typically leads to more frequent trading of securities within the portfolio, which is where the term “actively managed” comes from.

Index funds are considered passive funds because the portfolio makeup is determined by a common market index. For example, an index fund may be tied to the composition and performance of the S&P 500 index, or any number of indexes representing specific sectors, like healthcare, technology, bonds, or international securities.

With all the similarities between ETFs and mutual funds, what makes them different?

ETFs vs Mutual Funds – How They’re Different

Even though ETFs and mutual funds have many similarities, there are at least as many differences. We’ll explain those differences by breaking down the features offered by each fund type below.

ETF Features

The basic features that make ETFs unique from mutual funds include the following:

Usually Index Funds

In some ways, this is the major difference between ETFs and mutual funds, even though it’s not always true.

But as index funds, ETFs are designed to track an underlying market index. That means they’ll never outperform the index, but don’t underperform it either (though there may be slight variations due to fees charged within the fund).

The index nature of ETFs also means they’re passive funds. They don’t actively trade securities within the fund but do so only when the composition of the underlying index changes. For example, if an ETF is an index fund based on the S&P 500, trading of securities within the fund will only occur if the S&P 500 adds new companies or removes existing ones.

The lower trading frequency of index-based ETFs means low expense ratios. These are the expenses of managing the fund and include 12b-1 fees, management fees, administrative fees, operating costs, and all other asset-based costs incurred by the fund. These fees are charged by all ETFs, and can range from a low of 0.2% to a high of 0.20% per year on index-based ETFs.

Typically Tax Efficient

That’s the result of passive management – a fund that doesn’t trade securities frequently generates less in the way of taxable capital gains. And when they do sell securities, they’re most frequently long-term capital gains, which have lower tax rates than short-term capital gains (which are taxed at ordinary income tax rates).

In fact, since ETFs trade like stocks, the biggest capital gain is likely to come when you sell your shares in the fund. If that’s more than one year from the time the shares were purchased, any gain will be subject to the lower long-term capital gains tax rate.

Buying and Selling ETFs

ETFs sell on stock exchanges and can be purchased through a broker. They have two major advantages over mutual funds when it comes to buying and selling:

Minimum investment amounts. ETFs typically have no minimum investment requirement. You can choose to invest as little as $10 in a fund, or as much as $100,000 or more. That means ETFs are an excellent choice for first-time and small investors, particularly if you want to diversify among several funds.

In addition, since ETFs trade on stock exchanges, they can be bought and sold throughout the day at whatever the price is at the time of the transaction. For example, if a share price closed at $25 the previous day, but drops to $24 by 11:00 this morning, you can purchase the fund at $24 per share.

Trading commissions. A few years ago, a trading app known as Robinhood introduced the concept of commission-free trading. But a real revolution was launched in 2018, when the investment brokerage giant Charles Schwab rolled out commission-free trading of stocks, options, and ETFs. As the leader in the brokerage industry, nearly every other broker has been forced to follow suit. You can now buy and sell ETFs commission-free with nearly any broker.

You’ve probably also heard of load fees. Those are percentage-based fees charged when buying and (sometimes selling) funds. But load fees apply only to mutual funds, not to ETFs. Here are some brokers that offer free trades. 

Mutual Fund Features

The basic features that make mutual funds unique from ETFs include the following:

Often Actively Traded Funds

Mutual funds can be index funds, and that includes some of the most popular index funds in the field. But the primary attraction of mutual funds is active portfolio management.

With active trading of securities, the mutual fund manager is attempting to outperform the market. This is done by actively buying companies that are expected outperform the market while selling those that may be underperforming (or expected to). Actively managed funds are not determined by the composition of any underlying index. Their composition is decided entirely by the fund manager. 

How often do actively managed funds outperform the market? Not often. CNBC reported that actively managed large cap funds underperformed the S&P 500 85% of the time over a recent ten-year period, and 92% of the time over 15 years.

Active trading means higher expense ratios. Actively managed mutual funds have higher expense ratios than index funds, typically running between 0.50% and 1.00% per year.

Typically Create Short Term Capital Gains

Hopefully, most of those gains will be long-term, and subject to lower tax rates. But the frequency of trading in a mutual fund may also generate more short-term capital gains, which will be taxable at higher ordinary tax rates.

Buying and Selling Mutual Funds

Mutual funds are available either through brokers or fund families. Popular fund families include Vanguard, Fidelity Investments, and American Funds.

Unlike ETFs, where prices change continuously throughout the day, mutual fund values are set at the end of each trading day. That means if the price (net asset value) of a mutual fund fluctuates throughout the day you’ll get the price at the close of trading no matter what time of the day you executed the trade.

If you’re going to invest in mutual funds, you should be aware of the following:

Minimum investment amounts. Unlike ETFs, which have share prices and trade on stock exchanges – and can be purchased in very small dollar amounts – mutual funds are sold in minimums. The majority of mutual funds require a minimum initial investment of $2,500, though you can get some that will require less.

Trading commissions. Remember, I said brokerage firms have eliminated commissions on stocks, options, and ETFs? Conspicuously absent from that list are mutual funds. Most brokerage firms will charge a commission of anywhere from $10 to $50 to buy or sell a position in a mutual fund

However, many brokerages offer a select number of commission-free mutual funds. And fund families typically charge no commissions if you purchase one of their funds directly.

Load fees. We discussed these briefly under EFTs, where they don’t apply. But they often do apply to mutual funds. A load fee is basically a sales commission, generally ranging between 1% and 3% of the dollar amount of the fund you’re purchasing. The load can be charged upfront, upon sale, or both.

For example, there may be a 1% load at purchase and a 1% load upon sale. Very often, the load fee charged upon sale will be waived if you hold the fund for certain minimum amount of time, like two years.

Load fees are more typical of brokerage firms and can typically be avoided if you purchase a fund through the issuing fund family.

ETFs vs Mutual Funds – Which is the Better Investment?

For most investors – especially new and small ones – ETFs are almost certainly the better choice. They require no minimum investment, can be acquired commission-free, and generate little in the way of taxable short-term capital gains. And since they’re primarily index-based, you won’t underperform the market.

Mutual funds are better suited to larger and more experienced investors. Larger, because they do have minimum initial investment requirements that will necessitate a larger portfolio if you want to diversify among several funds. But more experienced because investing in actively traded funds does involve more risk than index funds.

While ETFs seem to have the upper hand based on these features, mutual funds are still much more popular.

The Investment Company Institute reports there were 9,414 mutual funds, compared with 2,175 ETFs in 2019. Mutual funds are also the much larger fund category based on total fund assets. Again for 2019, mutual funds held nearly $21.3 trillion, while ETFs have just under $4.4 trillion.

Those statistics may not offer much guidance in helping you decide between the two. But it does go to show that the general investing public still has a lot of confidence in mutual funds, despite the obvious advantages of ETFs.

Summary

Though the virtues of ETFs are being shouted from different corners of the financial universe, both fund types have merit. You may want to start out with index-based ETFs as a beginning investor, but gradually add actively traded mutual funds as your investment portfolio and experience grow.