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Mutual funds and exchange-traded funds (ETFs) are investment vehicles that consist of multiple assets. They hold shares in different stocks, for instance, or combinations of other securities, such as bonds or shares in real estate investment trusts (REITs). Both mutual funds and ETFs allow you to invest in a range of holdings via a single purchase—diversifying your portfolio in a way that typically carries less risk than investing in a single company or security.
There are key differences, though, in the way these funds are managed and traded, and in their costs and tax consequences. Read on for an overview of their advantages and drawbacks.
What Is a Mutual Fund?
A mutual fund is a group investment in which fund owners contribute cash, and professional managers trade and oversee a batch of investments that make up the fund. The nature of that batch can vary by security type (such as stocks, bonds and currencies); by industry (all aerospace or energy stocks, for instance); and by geography (all U.S. securities, or all overseas holdings, for instance). Some mutual funds are indexed, with holdings that mirror the S&P 500, NASDAQ 100 or other market indexes.
There were nearly 8,000 mutual funds available to U.S. investors in 2019, with holdings grouped according to a host of different criteria, so there are likely index funds that'll enable you to invest in any particular economic niche that interests you. Prices of mutual fund shares are set daily at the market close, so they are less susceptible to fluctuations that may affect their component stocks or securities during a trading day.
Actively Managed Mutual Funds
Most mutual funds are run by professionals who trade the funds' holdings in an effort to outperform average market returns. There's no guarantee any fund manager can do that consistently, of course, and a portion of the fund is used each year to compensate the managers.
Indexed Mutual Funds
A relatively recent addition to the mutual fund marketplace are indexed funds, with holdings that mirror the stocks in market indexes such as the NASDAQ 100, Fortune 200 or any number of industry-specific indexes. As with ETFs (see below), passive management of indexed mutual funds means lower management fees for investors.
Mutual funds often require a minimum initial investment, meaning you must put up anywhere from $500 to $5,000 to buy into the fund, after which you can increase your position with regular contributions, such as paycheck deductions.
What Is an Exchange Traded Fund?
Like indexed mutual funds, ETFs are pools of securities, typically grouped to mirror the composition of specific market indexes. Unlike mutual funds, however, they are traded daily like stocks, with pricing that fluctuates with supply and demand.
This creates some opportunity for savvy investors to buy low and sell high in response to changing market conditions, but ETFs are not designed for constant buying and selling. Many ETF providers impose extra fees on trades of shares that haven't been held a minimum period of time, to discourage day trading.
ETFs are usually passively managed, with component securities traded only as needed to match the composition of the indexes they mirror. This means they typically carry lower fees than actively managed funds.
Unlike mutual funds, you cannot purchase partial shares in ETFs, which means it‘s impractical to increase your stake in an ETF through regular incremental contributions, such as payroll deductions. lf you want a greater stake in an ETF, you must buy additional whole shares at prices that vary constantly. For this reason, ETFs are not well-suited to 401(k) funds, and they are not widely available as 401(k) investment options.
How Do Mutual Funds and ETFs Compare?
The following table summarizes the main differences between mutual funds and exchange-traded funds:
| Comparison of Mutual Funds and ETFs | ||
|---|---|---|
| Mutual Fund | ETF | |
| Management | Most are actively managed by professionals in an effort to outperform the market. Indexed mutual funds passively mirror market indexes. | Passively managed; adjusted as needed to mirror market indexes. |
| Trading | Market value is assigned daily when the market closes, and shares trade at that price until the next closing bell. | Shares trade continually throughout trading day and price fluctuates with supply and demand. |
| Fees | Managers are compensated for actively managing fund portfolios. Indexed mutual funds incur fewer trades and offer lower fees. | Passive management approach (tracking index) means fewer changes in holdings and lower fees. |
| Entry costs | Initial buy-in is typically steep, at $500 to $3,000. After that threshold is met, you can increase your position continually with regular contributions to the fund. | You can buy and sell ETF shares anytime at the posted market price. |
| Tax consequences | When fund managers sell securities at a profit, proceeds are distributed to fund owners annually, creating possible exposure to capital gains tax every year. This is not an issue for mutual fund investments held in 401(k) or other tax-deferred retirement programs. | Most transactions needed to adjust ETF fund makeup do not generate capital gains distributions to fund owners. Thus, ETF owners largely avoid capital-gains tax exposure until they sell their shares. |
| Expense ratio (Portion of fund used for administrative costs and advertising—independent of trading fees, manager compensation, etc.) | By law, these can range from 0% to a maximum of 2%. The average mutual fund expense ratio is 0.74%, which means you pay $74 for every $1,000 you invest. | Overhead on ETFs is typically lower than on mutual funds (but not in every case). The average ETF carries an expense ratio of 0.44%, meaning you pay $44 for every $1,000 you invest. |
Which Is Better for You?
Mutual funds and exchange-traded funds both offer diversified investment in a single package, but they have different underlying strategies and advantages.
Mutual funds are best thought of as a "buy and hold" approach. Managed funds, in particular, are meant to be invested in over decades. Over that time span, the expectation (which is never guaranteed) is that managers' efforts to beat the market will succeed more often than not, leaving you with an investment that has grown at a rate exceeding that of the market overall. The philosophy with a mutual fund is to ride out the ups and downs of the market with the goal of coming out ahead in the long haul.
ETFs are designed more for investors who crave greater control, and who want the opportunity to try to beat the market themselves through more frequent trades. As with any security, frequent trading can be risky, and gains you achieve in the process may be offset by fees you pay the broker and exchange on each transaction, but you can be more nimble with an ETF than a mutual fund.
The Bottom Line
Mutual funds and ETFs are both great vehicles for diversifying your investments (and spreading out risk) through a single, focused investment vehicle. Which is better for your next investment depends on your goals, your appetite for risk, and the nature of your other investments. When weighing a choice between mutual funds and ETFs, it's also important to consider your comfort level with trading on a daily basis (and trust you won't act impulsively if market conditions change quickly).
As with any investment decision, it's wise to consult with a professional who can review your particular situation and the consequences your choice may have for your financial big picture.