What Are Mutual Funds and ETFs?
To start comparing mutual funds and exchange-traded funds (ETFs), it’s important to understand what each one is. Mutual funds are pooled investment vehicles managed by professional fund managers. When you invest in a mutual fund, your money is combined with that of other investors and allocated across a portfolio of assets such as stocks, bonds, or a mix of both. The fund is typically designed to achieve a specific goal, like growth, income, or a balance of the two.
ETFs, on the other hand, are similar in that they also pool investor money to invest in a variety of assets. However, ETFs trade on stock exchanges, much like individual stocks. This means that their prices fluctuate throughout the trading day, and you can buy or sell them whenever the market is open. ETFs often aim to track the performance of a specific index, such as the S&P 500.
While the basic premise of diversification applies to both, mutual funds and ETFs differ significantly in structure, costs, and how they are managed. Understanding these foundational differences can help you determine which option aligns better with your investment style and financial goals.
Fees and Expenses: Understanding the Costs
One of the most significant differences between mutual funds and ETFs lies in their fee structures. Mutual funds typically come with higher expense ratios, which include the costs of professional management, administrative expenses, and sometimes marketing fees known as 12b-1 fees. On top of that, some mutual funds charge sales loads, which are essentially commissions paid either when you buy into the fund (front-end load) or sell your shares (back-end load).
ETFs, by contrast, are known for their cost efficiency. The expense ratios for ETFs are generally lower because they are often passively managed, meaning they simply aim to replicate the performance of an index rather than actively trying to outperform it. Additionally, ETFs don’t have sales loads, although you will incur brokerage fees when buying or selling them. These fees can add up if you trade frequently, so it’s worth considering your trading habits.
Another cost factor to consider is tax efficiency. Mutual funds are less tax-efficient because their structure requires fund managers to distribute capital gains to shareholders annually. This can trigger a tax liability even if you didn’t sell your shares. ETFs, on the other hand, are designed to minimize capital gains distributions, making them more tax-efficient for long-term investors1.
Flexibility and Accessibility
When it comes to flexibility, ETFs have the upper hand. Because they trade on stock exchanges, you can buy and sell ETFs throughout the trading day at market prices. This makes them an attractive option for investors who want more control over the timing of their trades. Additionally, ETFs allow you to set limit orders or stop-loss orders to manage your investments more precisely.
Mutual funds, in contrast, are less flexible. They are priced only once a day, after the market closes, based on the fund’s net asset value (NAV). This means you don’t have the ability to react to intraday market movements. For long-term investors, this limitation might not matter much, but it can be a drawback for those who prefer more dynamic trading options.
In terms of accessibility:
- Mutual funds: Often have minimum investment requirements, which can range from a few hundred to several thousand dollars.
- ETFs: Do not have such minimums, making them more accessible to beginner investors. With the rise of fractional shares offered by many brokerage platforms, you can even invest in ETFs with as little as a few dollars2.
Active vs. Passive Management
A key distinction between mutual funds and ETFs is how they are managed:
- Mutual funds: Many are actively managed, meaning a professional fund manager or team actively selects investments with the goal of outperforming the market. This hands-on approach can be appealing to investors who want expert guidance, but it comes at a cost—both in terms of higher fees and the risk of underperformance. Studies have shown that many actively managed funds fail to consistently beat their benchmark indices over the long term3.
- ETFs: Predominantly passively managed, aiming to replicate the performance of a specific index rather than beat it. This passive approach results in lower fees and often more predictable performance, as the fund’s success is tied directly to the index it tracks.
That said, actively managed ETFs have started to gain traction in recent years, offering a hybrid option for those who want the flexibility of an ETF with some level of active oversight. These products are still relatively new, so it’s worth doing thorough research before diving in.
Which Should You Choose?
Deciding between mutual funds and ETFs ultimately depends on your investment goals, timeline, and personal preferences:
- If you’re seeking simplicity and don’t want to worry about managing your investments, a mutual fund might be the way to go. The professional management and goal-oriented structure can make them particularly appealing for retirement accounts or other long-term savings plans.
- If you value lower costs, tax efficiency, and the ability to trade throughout the day, ETFs could be a better fit. They offer flexibility and accessibility, making them ideal for both beginners and seasoned investors.
If you’re still unsure, consider starting small with an ETF to get a feel for how the market works before exploring more complex investment options.
Both mutual funds and ETFs have their strengths and weaknesses, so the “right” choice is the one that aligns with your financial goals and risk tolerance. Whichever path you choose, remember that the most important step is to start investing—because the sooner you begin, the more time your money has to grow.
FAQs
- What are the main differences between mutual funds and ETFs?
- Mutual funds are actively managed, often have higher fees, and are priced once a day. ETFs trade on stock exchanges like individual stocks, are typically passively managed, and offer lower fees.
- Which investment type is best for tax efficiency?
- ETFs are generally more tax-efficient due to their structure, which minimizes capital gains distributions compared to mutual funds.
1ETFs vs. Mutual Funds: Tax Efficiency published on February 15, 2023, from Investopedia
2Understanding Fractional Shares published on July 10, 2022, from Fidelity
3Why Do Most Active Funds Underperform? published on March 5, 2023, from Morningstar