When it comes to investing in diversified funds, two options dominate the landscape: mutual funds and exchange-traded funds (ETFs). Both allow you to invest in a basket of securities with a single purchase, but they work differently in important ways. Understanding these differences will help you choose the right investment vehicle for your goals.
What is a Mutual Fund?
A mutual fund is a pooled investment vehicle that collects money from many investors and uses it to buy a diversified portfolio of stocks, bonds, or other securities. The fund is managed by a professional portfolio manager who makes decisions about what to buy and sell.
Key characteristic: Mutual funds are priced once per day after the market closes. When you buy or sell shares, your order is executed at that day's closing net asset value (NAV).
What is an ETF?
An exchange-traded fund (ETF) is similar to a mutual fund in that it holds a basket of securities. However, ETFs trade on stock exchanges just like individual stocks, with prices that fluctuate throughout the trading day.
Key characteristic: ETFs can be bought and sold anytime during market hours at the current market price, just like buying shares of Apple or Amazon.
Key Differences Between Mutual Funds and ETFs
1. Trading and Pricing
This is the most fundamental difference between the two:
Mutual Funds
- Trade once daily at market close
- You get the NAV calculated at 4:00 PM ET
- Orders placed during the day execute at end-of-day price
- No intraday trading possible
ETFs
- Trade throughout the day on exchanges
- Prices fluctuate based on supply and demand
- Can use limit orders, stop losses, and other order types
- Can trade in pre-market and after-hours sessions
2. Costs and Expense Ratios
Both fund types charge expense ratios, but there are important differences in overall costs:
- ETFs typically have lower expense ratios: Many broad market ETFs charge 0.03% to 0.10% annually
- Mutual funds vary widely: Index mutual funds can be just as cheap, but actively managed funds often charge 0.50% to 1.50% or more
- Commission costs: Most brokers now offer commission-free trading for both ETFs and their own mutual funds
- Bid-ask spreads: ETFs have a spread between buy and sell prices that can add costs, especially for less liquid ETFs
3. Investment Minimums
This is an area where ETFs often have an advantage for new investors:
- ETFs: Minimum investment is the price of one share (or even less with fractional shares)
- Mutual funds: Many require minimums of $1,000 to $3,000, though some have no minimum
- Exception: Many brokers have eliminated minimums for their own mutual funds
4. Tax Efficiency
ETFs generally have a tax advantage due to their unique structure:
Why ETFs Are More Tax Efficient
ETFs use an "in-kind" creation and redemption process that allows them to avoid selling securities internally. This means:
- ETFs rarely distribute capital gains to shareholders
- You control when to realize gains by deciding when to sell
- Mutual funds often distribute taxable gains even if you did not sell
5. Management Style
Both mutual funds and ETFs can be actively or passively managed:
- Passive (index) funds: Track a benchmark index with minimal management. Available in both structures
- Active management: Historically more common in mutual funds, but active ETFs are growing rapidly
- Cost difference: Active management costs more regardless of structure
When to Choose Mutual Funds
Mutual funds might be the better choice in these situations:
- Automatic investing: Setting up recurring automatic investments is often easier with mutual funds
- Dollar-cost averaging: You can invest exact dollar amounts ($100 per month) rather than buying whole shares
- Retirement accounts: Many 401(k) plans only offer mutual funds
- Active management preference: If you want a specific actively managed strategy, mutual funds may have more options
- No trading temptation: Since you cannot trade intraday, you are less likely to make emotional decisions
When to Choose ETFs
ETFs might be the better choice in these situations:
- Tax efficiency matters: In taxable brokerage accounts, ETFs generally create fewer tax events
- Trading flexibility: If you want to use limit orders or trade during market hours
- Lower minimums: When starting with small amounts, ETFs are often more accessible
- Broad diversification: ETFs cover nearly every market sector and asset class imaginable
- Cost consciousness: The cheapest index ETFs have rock-bottom expense ratios
Cost Comparison Example
Let us compare the long-term costs of a mutual fund versus an ETF tracking the same index:
$50,000 Investment Over 20 Years (7% Annual Return)
- ETF with 0.03% expense ratio: Grows to approximately $191,800
- Mutual fund with 0.15% expense ratio: Grows to approximately $187,400
- Actively managed fund with 0.75% expense ratio: Grows to approximately $170,600
The difference between the ETF and actively managed fund is over $21,000 just from fees.
Can You Own Both?
Absolutely. Many investors use both mutual funds and ETFs in their portfolios:
- Use mutual funds in retirement accounts where automatic investing is convenient
- Use ETFs in taxable brokerage accounts for tax efficiency
- Mix and match based on what each fund type offers for specific asset classes
Common Misconceptions
Myth: ETFs Are Always Cheaper
Not always true. Some index mutual funds have expense ratios as low as ETFs. Always compare specific funds rather than assuming.
Myth: Mutual Funds Are Outdated
Mutual funds still hold trillions in assets and remain popular, especially in retirement accounts. They offer legitimate advantages for certain investors.
Myth: ETFs Are Only for Day Traders
While ETFs offer intraday trading, most ETF investors are long-term buy-and-hold investors who never trade during the day.
How to Decide
Ask yourself these questions:
- Where is this money? Retirement account or taxable brokerage?
- How will I invest? Lump sum or regular automatic contributions?
- Do I need trading flexibility? Will I use limit orders or trade intraday?
- What specific fund do I want? Compare the actual expense ratios and features
- What does my broker offer? Check commission costs and available funds
Track All Your Fund Investments
Pro Trader Dashboard helps you monitor both mutual funds and ETFs in one place. Track performance, analyze holdings, and make informed decisions about your investments.
Summary
Mutual funds and ETFs are both excellent tools for building a diversified portfolio. The "better" choice depends entirely on your specific situation:
- Choose mutual funds for automatic investing, retirement accounts, and when you prefer simplicity
- Choose ETFs for tax efficiency in taxable accounts, trading flexibility, and potentially lower costs
- Choose both when different accounts or situations call for different solutions
The most important decision is not mutual fund versus ETF, but rather what you invest in and that you invest consistently over time. Both vehicles can help you build long-term wealth.
Ready to explore more investment options? Learn about index fund basics or discover bond investing fundamentals.