Automatically receive the internet’s most informative articles bi-weekly via our free bi-weekly Market Intelligence Report newsletter (sample here). Register in the top right hand corner of this page.
ETFs and mutual funds are the two most popular types of investment funds…and are considered a great way to have a diversified portfolio but if you are undecided about which one to invest in…then you should probably pick the ETF. This article explains why.
ETF vs. Mutual Fund: Key Differences
What ETFs and mutual funds have in common is that they pool money together from many investors and hold collections of different assets but there are also some key differences as summarized in the table below:
|Management||Usually passive||Usually active|
|Trading hours||Market hours||At market close|
|Expense ratios||Low to medium||Low to high|
|Ticker symbol length||2-4 letters||5 letters|
|Minimum investment||Low (1 share)||Medium to high|
|Limit and stop orders||Yes||No|
|Investment units||Shares||Dollar amounts|
|Passive index fund||Usually||Sometimes|
The main differences between an ETF and a mutual fund are:
- An ETF, or exchange-traded fund, is usually a passively managed fund that tracks a market index. It can be traded on a stock exchange, just like a stock.
- Mutual funds are usually managed actively, with a fund manager who regularly buys and sells assets within the fund.
- Even though ETFs are usually passively managed and mutual funds usually actively managed, there are exceptions to this. You can also buy actively managed ETFs and passively managed index mutual funds.
- A mutual fund can only be bought or sold at market close.
- The minimum investment is higher in the mutual fund.
- ETFs tend to have significantly lower expense ratios than mutual funds, which is largely due to the costs of having active managers controlling the investments in the mutual fund. However, passively managed index mutual funds tend to have very low expense ratios, just like passive ETFs.
- Mutual fund investors often save on commissions because they can buy them commission-free from the mutual fund provider but many brokers now also offer commission-free trading on ETFs, so this is no longer a distinct advantage for mutual funds.
- ETFs are considered to be more tax-efficient than a mutual fund as mutual funds need to buy and sell assets regularly, which creates capital gains that are then distributed to investors once per year.
- ETFs usually don’t buy and sell their assets in the same way as mutual funds, so there are much fewer taxable events occurring in an ETF. If you make a profit from an ETF, then you only pay a capital gains tax when that profit is realized…but if you own a mutual fund, then you will receive a capital gains payment at the end of each year and need to pay a capital gains tax. That being said, if you are investing in a tax-advantaged retirement account like a 401(k) or IRA, then the tax efficiency of the two types of funds is very similar.
Does one have better performance than the other?
There is no inherent performance difference between an ETF and a mutual fund…but given that ETFs usually have lower expense ratios and are more tax-efficient, this may give them a minor edge when it comes to long-term performance.
Benefits of choosing an ETF
…Here are some benefits of choosing an ETF instead of a mutual fund:
- Lower expenses – ETFs tend to have a lower expense ratio, sometimes as low as 0.03%. That’s only $0.30 per year for every $1,000 invested.
- Transparency – Most ETFs disclose their holdings every single day, so you know exactly what you are investing in. Mutual funds are only legally obligated to disclose their holdings each quarter.
- Tax efficiency – ETFs tend to be more tax-efficient than mutual funds, which gives them a slight advantage for investment returns.
- Trading flexibility – It is much more flexible to buy and sell ETFs. You can trade them during market hours, sell them short and even trade options on them.
- Low minimum investment – ETFs tend to have a much lower minimum investment than their mutual fund counterparts.
- Exposure – You can get exposure to all kinds of niche markets and geographies with ETFs. The investing landscape is more limited with mutual funds.
If you are a long-term passive investor doing your investing in a tax-advantaged account, most of the advantages of an ETF disappear. In that case, it may suit you better to set up an automated investing plan with a low-cost index mutual fund provider.
Benefits of choosing a mutual fund
Even though ETFs are generally considered better, investing in mutual funds also has some advantages:
- Dollar investing – You can buy a fixed dollar amount of a mutual fund and get partial shares in the fund. This is not always possible with an ETF.
- Automation – It is often easier to automate your deposits, withdrawals, and dividend reinvestments in a mutual fund.
- Net asset value – The mutual fund always trades at net asset value, while you could lose a bit of money from the bid-ask spread on an ETF.
- Restrictions – Mutual funds only trading once per day can be a benefit for some people. If you are prone to impulsive decisions, then a mutual fund may make it easier to stick to your investment plan.
- Commissions – Many mutual funds can be bought commission-free, which is not always the case with ETFs. This depends on where you are buying the mutual fund from, some brokerages or banks may charge a substantial fee.
- Active management – In some cases, a mutual fund will be run by an incredibly effective manager that beats the market over the long-term. However, this is the exception rather than the rule.
Index funds are great for beginners
The term “index fund” can apply to both an ETF and a mutual fund. An index fund simply means that it is a fund that tracks an index of stocks, bonds, or other assets…It is often recommended for beginner investors…instead of spending time on stock picking. In fact, simply buying and holding the S&P 500 stock index has historically provided better returns than over 90% of professionally managed investment funds…
Which is better, an ETF or a mutual fund?
ETFs do have some benefits over mutual funds, such as lower minimum investment requirements and greater trading flexibility. [Moreover,] in many cases, they even provide better returns when accounting for expenses and taxes so, if you are undecided about which one to invest in and don’t have a particular reason to choose a mutual fund, then you should probably pick the ETF.
Editor’s Note: The original article by Kris Gunnars has been edited ([ ]) and abridged (…) above for the sake of clarity and brevity to ensure a fast and easy. The author’s views and conclusions are unaltered with no editorial comments included to maintain the integrity of the original article and are not to be construed as an endorsement of such by the editor. Any re-posting of this article requires a hyperlink to this post to avoid copyright infringement.