ETF vs. Mutual Fund: What’s the Difference?

When deciding how to invest your money, you’ll likely run into two types of funds: exchange-traded funds (ETFs) and mutual funds. But you may be wondering, ETF vs. mutual fund? What’s the difference? The two funds have a lot in common, but they are different in key ways. A financial advisor could help guide you with an investment plan. Here’s what you need to know to figure out which fund is right for you.

ETF vs. Mutual Fund: The Similarities

At their core, ETFs and mutual funds are quite similar. Both types of funds are collections of shares of many different stocks or bonds, grouped together and traded as one unit. Experts manage the funds, keeping track of each security within the fund. The fund’s performance is based on the performance of the individual stocks within the fund and the total number of shares.

Since both funds are a collection of securities, they are great ways to add diversification to your portfolio in one fell swoop. Both types of funds offer choices that mirror major indexes, like the S&P 500, thus providing you with a diverse fund reflecting the market as a whole.

You can choose from a variety of ETFs and mutual funds, depending on your investment goals and interests. Both ETFs and mutual funds offer bond funds, stock funds and sector funds, each of which has its own pros and cons. Whether you want to increase your investment income or mitigate your risk, there is a fund appropriate for you.

ETF vs. Mutual Fund: Three Key Differences

Core similarities aside, ETFs and mutual funds have some major differences when it comes to pricing and purchasing, management, fees and taxes.

Pricing and Purchasing

ETFs trade like stocks. You can buy and sell shares throughout the day, and the price fluctuates with the market and with supply and demand of that particular ETF. Trades can be made through your broker or brokerage account. You have the option of purchasing as little as one share of an ETF.

You buy mutual funds through a fund company, such as Vanguard or Fidelity. A mutual fund’s value is a net asset value, computed once per day based on the closing market prices of its securities. You purchase mutual funds based on value, not on number of shares. Mutual funds require a large initial investment, with minimums over $3,000. Minimums can run as high as $50,000.

Management and Fees

Since ETFs trade like stocks, you’ll be paying trade commissions to your broker every time you buy or sell. The funds themselves are set up as indexes, either mirroring a major index or focusing on a certain industry. Like stock shares, the shares of an ETF are held by a management company. The shares of an ETF are bought and sold directly. Annual fees for ETFs are typically below 1%.

Mutual funds are created by pooling money from all investors to buy shares of securities with the pooled money. Typically, a fund management team actively manages mutual funds. These analysts chart the activities of the securities in the fund. They also research new companies, and buy or sell holdings as needed to grow the fund. However, there is a type of mutual fund that doesn’t require management: index funds. These contain securities that replicate the activity of the market as a whole and thus don’t require day-to-day management.

Mutual funds make money through fees. Some mutual funds charge a load fee of 3% to 6%, which you must pay either when you make your investment (front-end load fee), or when you sell your investment (back-end load fee). No-load mutual funds are also available, but these will charge other fees, such as annual expense ratios.

Taxes

The biggest difference between mutual funds and ETFs when it comes to taxes is that mutual funds tend to create a lot of capital gains for clients, while ETFs don’t. Depending on the state you live in, capital gains could be taxed at a fairly high rate, meaning that mutual funds may be creating a tax burden that ETFs won’t.

Mutual fund investors also typically pay taxes for the turnover within the fund, since other parties buying or selling shares directly affect the size of the fund.

ETF vs. Mutual Fund: Pros and Cons

Choosing whether to invest in an ETF or a mutual fund is an important choice. There are advantages to each of the choices, so you’ll need to think carefully about what each of them bring to the table before directing your money toward any investment project.

ETFs

• More flexibility: ETFs are bought and sold on the market like stocks, so you can sell your shares whenever you want.
• Tax efficiency: ETFs generally don’t create capital gains, meaning your tax burden may be lower than with a mutual fund.
• Lower fees: ETFs often have lower fees than mutual funds.
• Low minimum investments: With mutual funds, the minimum investment is set by the fund manager and could keep some people from investing. With ETFs, you can buy as little as one share of the fund.

Mutual Funds

• More likely to be actively managed: If you are interested in active management, where a fund manager is trying to maximize your return rather than just tracking the market, a mutual fund is more likely to offer this.
• No commissions: ETF trades come with commissions, while mutual funds generally do not.

Which One Is Right for Your Situation

For investors using a taxable brokerage account, the way each fund handles internal transactions matters. ETFs are structured so that most buying and selling activity happens between investors on the exchange rather than inside the fund itself, which tends to generate fewer taxable distributions. Actively managed mutual funds buy and sell holdings more frequently, and those transactions can produce capital gains that get passed to all shareholders in the fund, including those who didn’t sell anything. Inside a 401(k) or IRA, this distinction largely disappears since the account defers or eliminates taxes on gains regardless of the fund structure.

For someone just getting started with a limited amount to invest, ETFs remove a barrier that mutual funds often create. Many mutual funds set minimums of $1,000 or more at the fund level, while ETFs trade share by share with no fund-imposed minimum. Fractional share trading at most major brokers has made this even more accessible.

For investors who want a professional team actively selecting holdings rather than tracking an index, mutual funds are where most of that activity is concentrated. Whether the cost of active management is worth paying depends on the specific fund and asset class, but the burden of proof falls on the active manager to demonstrate consistent value above and beyond what a low-cost index fund would have delivered.

Investors looking for a hands-off approach may prefer a low-cost index mutual fund at a single provider, which removes the need for a brokerage account, eliminates intraday pricing decisions and keeps the experience as simple as possible.

How Costs Compound Over Time

Fees quoted as a fraction of a percent can look negligible on a fund fact sheet, but compounded over decades, the actual dollar cost can be substantial.

Two investors each put $50,000 into funds returning 7% annually before fees. One holds a low-cost index ETF at 0.05% per year. The other holds an actively managed mutual fund at 1% per year. After 30 years the ETF investor ends up with roughly $370,000. The mutual fund investor ends up with roughly $275,000. The difference approaches $95,000, paid out in increments so small they never registered on any single statement.

That gap assumes both funds deliver identical gross returns. When the higher-cost fund also delivers lower returns, which happens more often than not over long periods in major asset classes, the difference grows wider. The fee drag is certain from day one. The return premium that is supposed to justify it is not guaranteed at all.

Front-end load fees create a different version of the same problem. A 5% load on a $50,000 investment means $2,500 goes to the fund company before a single dollar is invested. That $2,500 compounding at 7% over 30 years would have grown to roughly $19,000. A fee paid once at purchase has a much larger opportunity cost than its face value suggests.

There are fund categories where active management has historically added enough value to justify higher costs, particularly in less liquid or less followed corners of the market. For broad exposure to large domestic equities or major bond indexes, however, the case for paying significantly more in fees has been difficult to make consistently over time. Knowing what a fee difference actually looks like in dollar terms over a realistic holding period is one of the more useful inputs a fund investor can have.

Bottom Line

ETFs and mutual funds are both effective ways to diversify a portfolio, spreading an investment across an index of securities for the cost of just a few shares. Deciding between the two often comes down to how much you have to invest, how hands-on you want your management style to be, and whether your goals are more short-term or long-term.

That diversification is really the core appeal of both vehicles. “The big advantage of investing in either ETFs or mutual funds is that you get instant diversification, unlike investing in a single stock or bond. One fund can include hundreds or even thousands of securities, spreading your risk out among different companies or even industries. The result is that losses are offset, and ideally, your returns are more stable over time. In the end, choosing between an ETF and a mutual fund may come down to the fees and specific underlying investments,” said Tanza Loudenback, CFP®.

Tanza Loudenback, CFP® provided the quote used in this article. Please note that Tanza is not a participant in SmartAsset AMP, is not an employee of SmartAsset and has been compensated. The opinion voiced in the quote is for general information only and is not intended to provide specific advice or recommendations.

Tips for Choosing Investments

• A financial advisor can help with identifying and reaching goals, as well as taking on much of the work. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• Consider how soon you want your money back. If you’re saving for the short-term, like for a down payment for a new house, an investment like a mutual fund won’t be right for you.
• Be aware of the fees and charges involved. As is the case with an ETF vs. mutual fund, trading and management fees vary, as does tax efficiency.

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