Investing is a constant challenge, and it’s worth it to investigate tools that can help reduce risk, maximize returns and let you come out on top of the roller coaster called the stock market. Exchange-traded funds (ETFs) and mutual funds are two tools that have this ability.
While ETFs and mutual funds demonstrate many similarities, there are also important differences.
What is an ETF?
ETFs are baskets of stocks that allow investors to buy and sell multiple stocks with something in common all at once. Trading a basket of stocks can reduce transaction costs compared to trading individual stocks separately. It also helps mitigate volatility since market price movements of an ETF are an average of multiple stocks, making volatility smaller than that of a single stock. Many investors view ETF investing as a safer option compared to individual stock picking. Additionally, ETFs are overseen by an investment professional or a multitude of portfolio managers, who are experts in selecting appropriate securities and determining their appropriate weight in the fund.
What is a Mutual Fund?
Mutual funds are also baskets of stocks that enable investors to buy and sell multiple stocks together. Similar to ETFs, trading a basket of stocks in a mutual fund can reduce transaction costs and manage volatility. Mutual funds are considered safer by some investors compared to investing in individual stocks. They are managed by professional portfolio managers with expertise in selecting suitable securities and their weight within the fund.
The Differences Between ETFs and Mutual Funds
Fees and Expenses
Fees and expenses differ between the two. With ETFs and mutual funds, an investor will indirectly pay for the expense ratio, which is what it costs the managing organization to manage the fund. Mutual funds’ expense ratios tend to be somewhat higher, typically ranging from 0.5% to more than 2%, while the typical expense ratio of an ETF ranges from 0.1% to 1.5%. This might seem like a slight difference, but it adds up over time.
You can expect to pay ETF trade commissions to a broker as well as any difference between the ask price — what you might expect to pay for the ETF when buying via a market order — and the bid price — what you might expect to receive for the ETF when selling through a market order. Depending on the broker and the liquidity of the ETF, these costs can be minimal or substantial.
ETF purchasers don’t have to bear the expense of loads, which are associated with some mutual funds. These loads are sales charges, and there are front-end loads — charged upon purchase — and back-end loads — charged upon fund redemption — associated with many mutual funds.
Other mutual funds are no-load funds, meaning that they do not charge these fund fees. Mutual funds might also involve a redemption fee that would be assessed before a specified time period. Mutual funds are priced, bought and sold once per day, typically at the close of the market.
In contrast, ETFs are continuously priced throughout the trading day and often in premarket and after-market sessions as well, offering greater flexibility because they can be traded much like stocks. As a result, active traders might consider ETFs a better choice than mutual funds.
Active vs. Passive
Active traders can do things with ETFs that aren’t necessarily possible with mutual funds. Examples include short-selling, options trading and trading on margin.
For passive investors, these factors might not mean much, but active traders are likely to prefer ETFs over mutual funds because of their flexibility. Passive investors may be able to take advantage of automatic investing plans that allow people to set up regularly scheduled purchases of mutual funds; these plans are typically not offered with ETFs. If you're thinking about buying ETFs, it's really a matter of if you prefer active vs. passive investing.
ETFs involve a lower turnover rate in their holdings when compared to mutual funds, resulting in fewer taxable events and less tax liability for investors with ETFs than with mutual funds.
Mutual funds pay a greater portion of their NAV in capital gains out to shareholders. More capital gains typically mean greater tax liability — another tax-time disadvantage with mutual funds compared to ETFs.
While individual brokers might require minimum investments, ETFs themselves do not generally have such requirements. Mutual funds, in contrast, sometimes have investment minimums, which might range anywhere from $500 to thousands of dollars. This feature can make mutual fund investing challenging or even prohibitive for those with small accounts.
ETFs and mutual funds are valuable investment tools with similarities and differences. ETFs have lower fees and greater trading flexibility, making them attractive to active traders. Mutual funds may be better for passive investors with automatic investing plans. Understanding these distinctions is important for aligning with investment goals and risk tolerance. By considering the unique features, investors can make informed decisions for success in the stock market.
Best Brokers for Investing in an ETF or Mutual Fund
Whether you're investing in ETFs or mutual funds, a great online broker is easy to use, charges low or no commissions and offers amazing customer service. Check out Benzinga’s top picks below.
- Best For:Active and Global TradersSecurely through Interactive Brokers’ website
- Best For:Traders of All Levelssecurely through Moomoo's website
- Best For:Intermediate Traders and Investorssecurely through Webull's app
- Best For:Beginnerssecurely through Robinhood's website
Frequently Asked Questions
Which is best for you?
Choosing the best option for your goals and circumstances depends on factors such as skills, interests, finances and risk tolerance. Thorough research and advice from experts can help guide the decision-making process. The best choice for you will align with your personal aspirations and lead to success and fulfillment.
Are ETFs riskier than mutual funds?
The risk level of ETFs and mutual funds depends on various factors such as underlying assets, investment strategy and market conditions. ETFs are typically passively managed and aim to replicate an index, while mutual funds can be actively or passively managed and have a broader investment mandate. Investors should evaluate specific investment funds to determine the level of risk involved.
Do ETFs pay dividends?
ETFs can pay dividends if the underlying securities in the ETF pay dividends. However, not all ETFs pay dividends as it depends on their composition and strategy. Some ETFs prioritize growth and capital appreciation instead of generating income through dividends.