ETFs vs. Mutual Funds: A Comprehensive Comparison for Investors

If you’re looking to diversify your investment portfolio in the stock market, there are a lot of options available. One of those options is stocks. But let’s face it, investing in stocks can be time-consuming. Instead of spending countless hours researching individual companies, many investors turn to funds.

Within the world of funds, there are different things to consider. We’re going to break down ETFs vs. mutual funds so you can make the best decision for your money goals and needs.

Understanding ETFs And Mutual Funds

Before we dive into the differences between an ETF and a mutual fund, along with detailing their pros and cons, we need to have a basic understanding of both investment types.

What Is An ETF?

An ETF (exchange-traded fund) is a group of securities – similar to an index fund – that are bundled together and sold on a stock market exchange through an investment broker. An ETF can be made up of many different things. They can include groups of stocks, bonds and even commodities.

Instead of purchasing shares of one company at a time as you would with individual stocks, ETFs provide you with a basket of hundreds or thousands of different companies. This helps investors create a much more diversified portfolio.

One feature of ETFs that many investors enjoy is that you’re allowed to buy and sell ETFs throughout the trading day, very similar to how you can buy and sell individual stocks.

What Is A Mutual Fund?

A mutual fund is a pool of money from different investors used to invest in a large group of assets (also known as securities) such as stocks and bonds. Mutual funds are run by money managers and base their investment choices on the funds’ investment strategy.

There are a lot of benefits to mutual funds. Similar to ETFs, they offer investors an affordable way to invest in a diversified portfolio of assets. Plus, all of the research is done for you by an experienced money manager. However, unlike an ETF, mutual funds can’t be bought and sold throughout the trading day. Instead, when you put in a buy or sell order, it’s executed at the end of the day based on the closing NAV (net asset value).

The Key Differences Between An ETF And A Mutual Fund

As you start to research ETFs and mutual funds, you might start thinking they look very similar. On the surface you’re right. Both types of funds pool money together into different securities. This allows investors to diversify their portfolio without the need to buy stock in a bunch of individual companies. However, even with all the similarities, there are also several differences between ETFs vs. mutual funds. We’re going to walk you through each of them.

How They’re Managed

One of the biggest differences between ETFs and mutual funds is the way they’re managed. Mutual funds are actively managed by a professional fund manager. Their job is to buy and sell different investments for the fund, hoping they can beat the overall market. Most ETFs, on the other hand, are passively managed. They typically follow an individual market index.

ETFs have grown significantly since robo-advisors have exploded in popularity. If you have an account with a robo-advisor like Betterment, Vanguard Digital Advisor, or Acorns, there’s a good chance you’re investing in ETFs.

How They’re Traded

Another difference between ETFs and mutual funds is the way they’re traded. Mutual funds, both actively managed funds and funds that track an index, can only be bought and sold once a day, after the market closes. The transactions would take place through the fund’s platform or with a brokerage. ETFs, on the other hand, can be bought or sold, through a brokerage, at any time throughout the trading day, similar to the way individual stocks can be bought and sold.

Expense Ratios

Both mutual funds and ETFs have an expense ratio. This is the amount you’ll pay each year to hold the fund in your portfolio. While both funds include expense ratios, the difference lies in the percentage that each charge investors. According to Morningstar, the average expense ratio for an actively managed mutual fund is 1.09%. The average expense ratio on index mutual funds is slightly less at 0.79%. In contrast, the majority of all ETFs are passively managed and have an average expense ratio of 0.57%. The select actively managed ETFs have an average expense ratio of 0.76%.

How They’re Taxed

When it comes to how ETFs or mutual funds are taxed, there’s a pretty big difference. If an investor purchases an ETF, they aren’t going to pay capital gains tax until they sell the investment. This is because the buying and selling is done by an outside party and not the fund. However, with a mutual fund, if the fund manager sells out of a position, you’ll end up paying capital gains taxes even if you don’t sell your position in the fund itself. These differences make it much more tax-efficient to invest in ETFs vs. mutual funds.

Cost Of Entry

Most mutual funds will have a minimum amount that you’ll need to invest, as well as a minimum amount for subsequent investments. This can be anywhere from a few hundred dollars up to a five-figure investment. As an example, the T. Rowe Price Blue Chip fund (TRBCX) has a minimum initial investment of $2,500 and a minimum subsequent investment of $100. In contrast, ETFs don’t have a minimum investment. Instead, you just pay whatever the share price for the fund might be.

Mutual Funds Are Popular For Retirement Plans

If you’re investing in a 401k plan through your employer, you’re most likely invested in mutual funds and not ETFs. The reason for this is because many consider ETFs to be very close to a speculative investment causing 401k managers to steer away from adding these to their portfolios.

ETF vs. Mutual Fund: Weighing Your Options

Before you make any investment it’s important that you weigh all of your options and make sure you have all the information needed to make a good investment decision for your situation. When considering an ETF or mutual fund there are pros and cons to both. Here are some of them that you should consider.

ETF Pros And Cons

Pros

• Liquidity – Investors love liquidity. It allows them to be able to buy and sell whenever they’d like. With ETFs you can buy and sell at any time throughout the trading day.
• Low volatility – When you invest in a single company’s stock, volatility can be high if there’s market-moving information. However, with an ETF, there’s much less volatility because the fund is made up of entire sectors or indexes.
• Diversity – Diversification is a key principal for investing. You’ll need to make sure you’re investing in many different companies from different sectors to be properly diversified from risk. However, many EFTs are diversified across different business sections. For example, a large cap ETF could have positions in both growth and value stocks from different industries like financials, consumer discretionary and energy.
• Tax efficiency – Because of the way they work, capital gains or losses are typically only realized once you sell an EFT.

Cons

• Unknown Indexes – There are thousands of ETFs available to investors and new ETF are becoming available every month. While many of these track very liquid indexes, that’s not always the case. Some ETFs have very low trading volumes which can cause the bid-ask spread to be fairly large. If you’re looking to buy or sell your investment, this can drastically influence the price a market order gets placed at.

Mutual Fund Pros and Cons

Pros

• Professional portfolio management – Mutual funds are managed by professional fund managers. They buy and sell assets for the fund with the hopes they’ll be able to outperform the overall market. In exchange, a management fee is included in the expense ratio you pay for the fund. If being a self-directed investor isn’t for you then this is a small price to pay for professional advice.
• Dividend reinvestment – Once dividend and interest income is declared for a fund, you can use the extra cash to reinvest in more shares.
• Reduced risk – Most mutual funds invest in dozens and in some cases hundreds of different companies. This makes mutual funds a very diversified investment vehicle.
• Fair pricing – Unlike ETFs that can be bought and sold all day, mutual funds transactions only happen once a day. This reduces any potential for price fluctuations.

Cons

• High-expense ratios and fees – Even though you’re receiving professional management of the funds you’re investing in, the expense ratios for mutual funds can be high. The end result is a lower return. Look for funds that have expenses below 1.00%. Several large fund companies like Vanguard and T. Rowe Price have lower-cost mutual funds.
• Tax inefficiency – Because mutual funds buy and sell the assets they hold, you’ll end up paying capital gains taxes even if you don’t sell your position in the fund. This can increase the overall expenses you pay each year to hold the investment.
• Poor trade execution – When you place a buy or sell order for a mutual fund, anytime during the day before the close of trading, your order will be priced at the daily closing NAV price. If you’re planning to time the market or make short-term trades, this probably isn’t going to be the best option.

The Bottom Line: Should You Choose An ETF Or Mutual Fund?

If you’re looking to invest money in either an ETF or mutual fund, it’s important to do your research. If you’re more of a novice investor, then it might make sense to invest in mutual funds where you have professional money managers handling the research and making the investment choices. However, if you have a good understanding of how the market works and you’re more concerned about managing your expenses, then an ETF with a low expense ratio might be the best choice.