ETFs and mutual funds are both popular ways to invest in diversified portfolios, but they work differently. Understanding these differences will help you choose the right investment vehicle for your goals. In many cases, both can have a place in your portfolio.
The Basic Difference
Both ETFs and mutual funds pool money from investors to buy a basket of securities. The key difference is how they trade and how they are priced.
Quick comparison: ETFs trade like stocks throughout the day at market prices. Mutual funds trade once per day after the market closes at a price called the NAV (Net Asset Value). This single difference leads to many other distinctions between the two.
Trading and Flexibility
ETFs
You can buy and sell ETFs anytime during market hours, just like stocks. Prices change throughout the day based on supply and demand. You can use limit orders, stop losses, and other order types. This makes ETFs ideal for investors who want flexibility and control over their entry and exit prices.
Mutual Funds
Mutual funds only trade once per day at 4:00 PM Eastern when the market closes. No matter when you place your order during the day, you get the end-of-day NAV price. This works fine for long-term investors but limits tactical trading.
Example: Buying During a Market Drop
Say the market drops 3% at 10:00 AM and you want to buy the dip:
- With an ETF: You can buy immediately at the current price
- With a mutual fund: You place your order but will not know your price until 4:00 PM. If the market recovers, you miss the opportunity
Costs and Expenses
Expense Ratios
Expense ratios measure the annual cost of owning a fund. ETFs typically have lower expense ratios than mutual funds, especially when comparing index-tracking funds.
- Average ETF expense ratio: 0.03% to 0.50%
- Average index mutual fund: 0.10% to 0.50%
- Average actively managed mutual fund: 0.50% to 1.50%
Trading Costs
Most brokers offer commission-free trading for ETFs now. However, ETFs have bid-ask spreads (the difference between buying and selling prices), which is a hidden cost. Mutual funds have no spread, but some charge loads (sales fees) or redemption fees.
Minimum Investments
ETFs have no minimum beyond the price of one share, which could be as low as $50. Many mutual funds require minimums of $1,000 to $3,000, though some have lowered this recently.
Tax Efficiency
ETFs are generally more tax efficient than mutual funds due to how they are structured.
Why ETFs are tax efficient: When mutual fund investors sell, the fund manager must sell holdings to raise cash, potentially creating capital gains for all shareholders. ETFs use an "in-kind" redemption process that avoids this issue. You only pay taxes when you personally sell your ETF shares.
This matters most in taxable brokerage accounts. In tax-advantaged accounts like IRAs and 401(k)s, the tax difference does not apply since these accounts are already tax-sheltered.
Investment Minimums and Fractional Shares
ETFs
The minimum investment is one share. If SPY trades at $500, you need $500 to buy one share. However, many brokers now offer fractional shares, letting you invest any dollar amount.
Mutual Funds
Many mutual funds require minimums of $1,000 or more to open an account. Once invested, you can often add smaller amounts. Mutual funds automatically support dollar-amount investing since you buy in dollars, not shares.
Automatic Investing
Mutual funds have traditionally been easier for automatic investing. You can set up automatic transfers to invest $500 on the first of every month without worrying about share prices.
ETFs required buying whole shares at market prices, which made automatic investing complicated. However, with fractional shares now widely available, this advantage has largely disappeared.
Active vs Passive Management
ETFs
Most ETFs are passively managed, meaning they track an index like the S&P 500. Some actively managed ETFs exist but are less common.
Mutual Funds
Mutual funds come in both passive (index funds) and active varieties. Actively managed mutual funds have portfolio managers who try to beat the market through stock selection.
Performance Reality Check
Studies consistently show that most actively managed funds underperform their benchmark indexes over time:
- Over 15 years, about 90% of actively managed funds fail to beat the S&P 500
- The higher fees of active funds create a hurdle that is hard to overcome
- This is why low-cost index ETFs have become so popular
When to Choose ETFs
- You want to trade during market hours
- You prefer the lowest possible expense ratios
- Tax efficiency in a taxable account is important
- You want to use options strategies on your holdings
- You value transparency in knowing daily holdings
- You have a small amount to invest (under $1,000)
When to Choose Mutual Funds
- You want automatic investing without worrying about share prices
- You prefer not to think about bid-ask spreads or order types
- Your 401(k) offers good mutual fund options but no ETFs
- You want access to specific active managers with strong track records
- You are investing in a tax-advantaged account where tax efficiency does not matter
The Best of Both Worlds
Many investors use both ETFs and mutual funds in their portfolios:
- Use mutual funds in your 401(k) where ETFs may not be available
- Use ETFs in taxable brokerage accounts for tax efficiency
- Use mutual funds for automatic paycheck contributions
- Use ETFs for tactical adjustments when you want price control
Popular ETF and Mutual Fund Equivalents
Many index ETFs have mutual fund counterparts that track the same index:
- S&P 500: SPY/VOO (ETF) vs VFIAX/FXAIX (mutual fund)
- Total Stock Market: VTI (ETF) vs VTSAX/FSKAX (mutual fund)
- Total Bond Market: BND (ETF) vs VBTLX (mutual fund)
- International: VXUS (ETF) vs VTIAX (mutual fund)
These equivalent funds hold nearly identical investments, so your choice comes down to the structural differences discussed above.
Track All Your Investments
Pro Trader Dashboard tracks ETFs, mutual funds, stocks, and options in one unified dashboard. See your complete portfolio performance and make informed decisions.
Making Your Decision
For most investors, ETFs are the better choice for new investments due to their lower costs, tax efficiency, and flexibility. However, mutual funds remain excellent options, especially in retirement accounts.
The most important factor is not ETF vs mutual fund. It is that you are investing at all. A mutual fund investor who stays consistent will build more wealth than someone who endlessly researches the "perfect" ETF but never starts investing.
Summary
ETFs and mutual funds both offer diversification and professional management. ETFs trade like stocks with lower costs and better tax efficiency. Mutual funds offer simplicity and work well for automatic investing. Many successful investors use both. Choose based on your specific needs, account type, and investing style.
Learn more about investing with our guide on what an ETF is or discover index fund investing strategies.