Exchange-traded funds (ETFs) and mutual funds are among the most popular investments out there. They have a lot in common, too. You can think of them as bundles of various assets that offer investors immediate diversification. However, there are enough key differences to fuel a fierce ETFs vs. mutual funds debate in finance circles. This guide offers a detailed look at these differences to help you figure out which might be best for you.
You’ll find this information much easier to grasp if you have a handle on the basics of investing. Also, note that I go into great detail concerning the structure of ETFs and mutual funds to give you the clearest possible understanding. If you’re just looking for a comparison, read the Fast Facts section and then jump ahead to “Why Some People Choose Mutual Funds” via the Table of Contents menu below.
- Mutual funds generally feature active management. On behalf of investors, experts buy and sell assets with the intention of beating the market.
- ETFs typically feature passive management. Experts buy and sell assets to keep the fund in line with a benchmark index.
- In America, mutual funds date back to 1890. They’ve become the most popular investment in the country due to factors such as convenience and availability.
- ETFs are relatively new, having been developed in the 1990s. They have amassed considerable popularity since then, owing to perks such as drastically lower fees and historically superior performance.
ETFs vs. mutual funds: The basics
For the most part, the ETFs vs. mutual funds debate is related to the decades-old standoff between passive and active asset management. ETFs largely represent the former, with managers passively shuffling assets to keep the overall fund in line with indexes such as the S&P 500. Mutual fund managers, meanwhile, typically use their expertise to actively choose assets they believe will outperform indexes (aka “beat the market”). There are exceptions; you can find passively-managed mutual funds and actively-managed ETFs. These aren’t as common, however.
Done right, active management can deliver better investment returns than passive management. The challenge lies in finding managers who can pull this off. Data has shown that fewer than half of active stock funds in America outperform their passive competitors. This has resulted in headlines such as “ETFs are killing mutual funds” and insistence among many experts (including Warren Buffet) that passive management is the way most individual investors should go. As you’ll see in this piece, however, there are still good reasons one might choose to invest in mutual funds.
What do ETFs and mutual funds hold?
ETFs and mutual funds grant investors access to a variety of assets. The most common of these are:
- Money markets
- Other ETFs or mutual funds
- Some combination of the above
You can also find funds holding assets such as commodities and currencies.
Fund managers choose from these assets based on what type of “bucket” they’re trying to create. For example, a mutual fund or ETF may be geared towards helping customers invest in the American economy or something more specific such as the tech sector. Some funds simply target a specific investment strategy, such as “aggressive” (high risk, high reward) or “conservative” (stability with lower expected returns). A fund’s focus will often be pretty obvious based on its name. Popular examples (with the focus identifier bolded) include:
- SPDR S&P 500 ETF
- iShares MSCI Emerging Markets ETF
- Vanguard Total Stock Market ETF
- Fidelity Select Medical Technology and Devices Portfolio
- Diamond Hill Corporate Credit Fund
- TIAA-CREF Real Estate Securities Fund
Each fund also has documentation detailing its focus and holdings.
All about mutual funds
Most mutual funds have minimum initial investment requirements ranging from $500 to $5,000. This can put beginning investors at a disadvantage since it may take a few months to save up enough cash to get started.
As mentioned earlier, mutual funds are typically structured in a way that allows managers to actively trade assets with the intention of beating passive indexes. You pay for this in the form of higher fees, which are referred to as the fund’s management expense ratio (MER). These fees often lie between 0.5% and 1% but can climb beyond 1.5% in some cases. For comparison, ETFs have an average expense ratio of just 0.44%.
Rather than buying and selling mutual fund shares on an exchange, you’ll generally have to transact with the fund manager or a third party (such as a financial planner or advisor) that works with them on your behalf. This limits how frequently you can sell and receive price updates, which we’ll explore shortly.
Mutual fund sales load types
A mutual fund’s expense ratio is not necessarily the only fee you’ll pay as an investor. Some funds also have sales load fees, which serve as a commission for the third party selling the investment.
Front-end sales load
When you purchase a fund with a front end sales load, you’ll pay fees up-front. Federal regulations cap these fees at 8.5% but most are between 3% and 6%. This is still fairly substantial; a 6% fee on a $100,000 investment will cost you $6,000 right out of the gate. Mutual fund shares with a front-end sales load are sometimes referred to as “Class A.”
Back-end sales load
If a mutual fund charges a back-end sales load, that means you’ll pay fees upon selling your shares. Critics often point out that a back-end sales load can lead to nasty surprises for investors who don’t thoroughly read the fund’s description before purchasing. Say you net a 10% gain on a mutual fund and decide to sell your shares. If the fund has a back-end sales load, you’ll immediately pay a fee, erasing some of your gains. That can be quite inconvenient if you’re cashing out to cover an urgent expense. You’ll sometimes hear mutual fund shares with a back-end sales load referred to as “Class B.”
Deferred sales load
A deferred sales load is like the back-end type in that it doesn’t kick in until you sell your shares. However, the sales load decreases over time, eventually reaching nil. This encourages long-term investing. These shares are sometimes referred to as “Class C.”
Lastly, there are no-load mutual funds, which don’t charge any commissions. You’ll typically buy these shares directly from the fund company rather than through a third party.
How are mutual funds priced?
How a mutual fund derives its value depends on whether it’s open-end or closed-end.
An open-end fund’s price depends on its net asset value (NAV), or the worth of all underlying investments. This figure is calculated at the end of each trading day, at which point any open orders will be fulfilled. In other words, open-end mutual fund investors don’t actually know how much they’ll pay for shares at the moment of placing an order. They only know what the fund’s shares were worth at the end of the previous trading day. The same is true when selling shares. As such, activities like day trading are all but impossible with open-end funds.
Another key distinction is that shares are unlimited. Whenever an investor places an order, the management company will simply issue more shares. This doesn’t dilute the existing share value, though; new money is simply added to the fund’s pile of assets, making the entire “pie” bigger.
Truth be told, the majority of mutual funds you’ll encounter as an individual investor won’t fall into the closed-end category. It’s still good to know about them, though.
Closed-end funds behave more like ETFs in that you purchase existing shares (no new ones are created after the fund’s Initial Public Offering) from other investors on an exchange and values fluctuate based on market demand. Shares trading above NAV are described as being at a “premium” while those trading below are at a “discount.” Most closed-end funds fall into the latter category, which can be tempting for investors. There are reasons for this discount, though. Some academics theorize that it’s the high fees and poor liquidity typical of closed-end funds.
All about exchange-traded funds (ETFs)
Unlike mutual funds, ETFs don’t have formal minimum investment requirements. As long as you have enough money to purchase a single share and cover any commission fees your brokerage firm charges, you’re ready to start. This boosts their popularity among investors with limited money to throw into a single investment.
ETFs are passively-managed and usually track an index like the S&P 500, which represents stock from 500 of America’s largest publicly-traded companies. You can also find ETFs that target industry-specific indexes, such as technology or energy. Managers simply buy and sell assets in tandem with whatever is going on inside the index rather than attempting to outsmart it. This passive approach means lower fees for investors; as mentioned earlier, ETFs have an average MER of just 0.44%.
As the name would suggest, you buy and sell ETFs on an exchange (using the same mechanism for buying stocks) rather than directly from the fund company.
Legal structures of ETFs
Legally speaking, there are at least seven ETF structures out there. Truth be told, only one of these will likely concern you as a beginning individual investor. My goal is to give you as much information as possible, though, so I’ll discuss them all.
When you hear people mention ETFs, this is what they’re referring to 99% of the time. In fact, if you’re just looking to establish some general knowledge, you can jump ahead after reading this subsection.
Open-end ETFs invest in common assets like stocks and bonds. The legal structure prohibits investment in more “complex” assets like commodities.
Open-end ETF managers can automatically reinvest dividends while other types of ETFs require the distribution of those payments to investors. Dividend reinvestment can be a major advantage when it comes to growing your wealth over the long haul. This type of ETF also benefits from something called “pass-through taxation,” which is to say that any tax liability goes to you as the investor. This is good as it avoids double-taxation.
Exchange-traded unit investment trusts (UITs)
A UIT is legally recognized as a company that manages a portfolio of securities on behalf of its investors. The U.S. Securities and Exchange Commission (SEC) mandates that UITs seek to replicate a specific index. When the portfolio produces dividends, the company must distribute them to investors rather than reinvesting them. There are also some portfolio weighting restrictions. UITs feature pass-through taxation.
Exchange-traded grantor trust
With an exchange-traded grantor trust, investors actually own the ETF’s underlying assets rather than simply having partial ownership of the portfolio’s NAV. It’s a subtle twist that comes with perks such as voting rights in corporations whose shares are part of the fund. Exchange-traded grantor trusts commonly invest in commodities and face tighter government regulations than open-end ETFs. Investors also pay tax directly under this fund structure.
Exchange-traded notes (ETNs)
ETNs don’t actually hold underlying assets. Rather, shares are debt securities. The underwriting financial institution promises to make good on the debt by repaying investors (plus or minus any gains or losses) on a set date. If that firm is unable to make good on the debt, there are no underlying assets they can sell since the only thing backing an ETN is the institution’s credit rating. In practice, this scenario (known as a “default”) is rare. You should still account for the risk, though.
What’s the point of all this? Well, while you can find ETNs that target market indexes, you can also gain exposure to currencies and commodities that aren’t available through open-end ETFs.
This type of ETF is legally an unincorporated business. You’ll often hear people refer to these investments as “commodity ETFs” since they often trade assets like oil and natural gas. Fittingly, the U.S. Commodity Futures Trading Commission (CFTC) regulates this type of ETF. Fund managers must file financial disclosures and reports in keeping with the CFTC’s rules.
Exchange-traded managed funds (ETMFs)
ETMFs are something of a hybrid between mutual funds and ETFs. They feature active management like the former but investors can trade them on exchanges throughout the day as with the latter. This is a relatively new investment, having been approved by the SEC in 2014 under the brand name NextShares.
C Corporations do not benefit from pass-through taxation like other ETF types we’ve discussed thus far. Because of this, expense ratios can be quite high. C Corporations are advantageous for those looking to circumnavigate legal issues concerning investments in partnerships and special purpose vehicles.
How are ETFs priced?
Like mutual funds, ETFs have NAVs based on the value of their underlying assets. Because ETFs are traded on the open market, however, the value of a fund’s shares can fluctuate based on supply and demand. As with closed-end mutual funds, an ETF trading for more than NAV is said to be at a “premium” while one trading below NAV is at a “discount.”
One important thing to note is that ETFs fluctuate in value throughout the day. When you place an order, you don’t have to wait until the end of the day for it to be priced and executed. Rather, ETF trades can take mere seconds to execute.
Why some people choose mutual funds
If your preference in the ETFs vs. mutual funds debate isn’t already settled, perhaps a discussion of why people choose one over the other might help. I’ll leave out the shared benefits (i.e. instant diversification) and focus on what makes each one unique, starting with mutual funds.
Hands-on customer service
When buying stocks and ETFs, you can often feel like you’re on your own. Indeed, some financial institutions refer to accounts that facilitate these trades as “self-directed.” You analyze and choose stocks on your own, with your brokerage simply handling the administrative tasks.
With mutual funds, on the other hand, institutions often play the role of advisors. If you’re interested in one of their funds, you can have them walk you through the facts or perhaps even recommend an alternative from their suite.
Of course, the downside here is that these conversations can often feel like sales pitches. As you become a more experienced investor, you’ll quickly learn how to pick out the good advice from the sales chatter. Until then, those conversations will still generally be a net positive for you.
There’s a possibility of beating the market
As mentioned a few times throughout this piece, a key aspect of the ETFs vs. mutual funds debate concerns passive vs. active management. If you’re able to find a well-managed mutual fund that consistently beats the market, you’ll do quite well. The challenge lies in finding such a fund – but it’s not impossible.
On the other hand, practically speaking, you have no hope of beating the market with an ETF. In fact, you technically are the market. Depending on your investing goals, this average growth may not be good enough, in which case finding a mutual fund that beats the market might be preferable.
Mutual funds encourage long-term investing
Because ETF prices update regularly, some inexperienced investors tend to watch their portfolios like hawks throughout the day or even engage in swing trading without fully understanding what they’re doing. Because a mutual fund’s share value only updates once daily, these potentially reckless behaviors aren’t as common.
This point hits home at the importance of considering historical performance and your investor psychology when choosing an asset.
Why some people choose ETFs
Some of the loudest voices in the ETFs vs. mutual funds debate are those who swear by the former. Here are some of their arguments.
As mentioned earlier, the average ETF charges an MER of just 0.44% compared to 0.5%-1% or even 1.5% and beyond for mutual funds. While this may not seem like a huge difference when your funds are limited, it quickly adds up as your portfolio grows. Over the course of your entire investing lifetime, an ETF’s lower fees could save you tens of thousands of dollars.
Low minimum initial investment
Many mutual funds require initial investments of as much as $5,000. ETFs have no such requirements; your minimum investment will simply be whatever the asset’s price is, plus any brokerage commissions. Some popular ETFs cost less than $50. This is a huge advantage for investors without a lot of capital who want to get started as soon as possible and, perhaps, not be forced to put thousands into a single fund.
Historically better average returns than mutual funds
For many, this is the crux of the ETFs vs. mutual funds argument. Data has shown that passive management outperforms active management. It’s just very hard to consistently choose assets that beat the market. Even Warren Buffet struggled to do this over the last decade. This is reason enough for some people to choose passive ETFs over active mutual funds.
There are some definitely some very valid criticisms of this rationale, mind you. For example, just because ETFs have outperformed mutual funds in the past doesn’t mean that’ll be the case forever. Remember, the ETFs vs. mutual funds debate has no objective winner; it all depends on your goals and outlook, which you should discuss with an advisor.
You can make trades other than basic buys and sells
Many investors (especially beginners) are content with simple buy/sell orders. They may not even know other options exist. As you become more experienced, however, you’ll learn about stop-losses, limit orders, options trades, and market shorting. These can be very powerful wealth-building tools if you know what you’re doing – and they’re only possible with exchange-traded assets like ETFs.
Regular price updates can be useful
While mutual funds encourage long-term investing, there are undoubtedly situations in which an ETF’s constant price action would be advantageous. Intraday trading is one such situation. Markets can be very volatile throughout the day, which makes for “buy low, sell high” opportunities that would be impossible with mutual funds.
How to start trading ETFs or mutual funds
I trust this guide has been useful in helping you understand the ETFs vs. mutual funds debate and which side you might fall on. Whichever investment you ultimately choose, you’ll need an investment account to start trading it. My post on the types of investment accounts in the United States is a good place to start. Be sure to speak with an advisor before opening an account and settling on your first investment. They’ll be able to give you tailored advice for your specific situation.
Frequently asked questions
ETFs and mutual funds share many similarities. Both are essentially “buckets” of assets that offer investors immediate diversification. However, there are several differences as well. ETFs trade on exchanges, feature passive management, and fluctuate in price throughout the day. Mutual funds, on the other hand, feature active management and are priced just once daily.
It’s hard to say that any investment is objectively “better” than another (let alone ETFs vs. mutual funds, which are similar in many ways). It all depends on your goals and psychology. Mutual funds are generally geared towards long-term investors who appreciate convenience, believe active management can beat the market, and aren’t interested in the “technical” aspects of investing. ETFs, meanwhile, are popular among those who value low fees and believe passive management will continue to outperform active management.
Keeping in mind my prior remarks about the subjectivity of “better” investments, ETFs get the upper hand if you prefer lower fees and passive management. There are good reasons to hold this view; that combination has outperformed high-fee active management in recent years. Many investors also feel more in control of ETF-based portfolios since
With mutual funds, investors pay for a professional’s oversight and expertise, plus the operational costs associated with frequent trades. By comparison, many ETFs simply follow an index and trade less frequently, which requires less administrative work.
Every time a fund manager sells assets for a profit, a taxable event occurs. Because ETF managers sell assets less frequently, this is kept to a minimum. ETFs also trade between investors, whereas mutual fund trades are conducted with the fund manager sitting at the other of the table, so to speak. This means they have to buy and sell new assets whenever investors make deposits or withdrawals, respectively. That involvement has tax implications.