Investing is a constant challenge, and it’s worth it to investigate any tools that can help reduce risk, maximize returns, and come out on top of the roller coaster we call the stock market. ETFs (exchange traded funds) and mutual funds are 2 tools that have this ability.
While there are similarities between ETFs and mutual funds, there are also important differences.
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ETFs vs. Mutual Funds: Overview
ETFs and mutual funds are both “baskets” of stocks, meaning that they allow investors to buy and sell multiple stocks (generally with something in common) all at once. Purchasing or selling a basket of stocks has a number of advantages over stock picking, or buying and selling individual stocks.
For one thing, trading a basket of stocks can reduce transaction costs compared to trading each of the component stocks individually (consider, for instance, the time and expense it would take to buy or sell every stock in the S&P 500).
Buying a basket of stocks also has the advantage of mitigating volatility; the typical price movement of an ETF or mutual fund is going to be an average of the movements of multiple stocks, some of which will go up and some of which will go down, so the price action of a basket of stocks is typically going to be smaller than that of a single stock.
For this reason, some investors will consider ETF and mutual fund investing to be safer than individual stock picking. It’s also true that both ETFs and mutual funds are overseen by professional portfolio managers, who are considered experts in choosing the most appropriate securities to include in a fund as well as how much weight each security should have in that fund.
The Differences between ETFs and Mutual Funds
Fees and expenses
First of all, we must understand that the fees and expenses are different 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 we can expect the typical expense ratio of an ETF to range from 0.1% to 1.5%. This might seem like a slight difference, but it does add up over time.
Mutual funds vs. ETFs
You can expect to pay ETF commission costs 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.
On the other hand, ETF purchasers don’t have to bear the expense of loads, which are associated with some mutual funds. These loads are basically sales charges, and there are front-end loads (charged upon purchase) and/or 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 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 oftentimes in premarket and after-market sessions as well) and offer greater flexibility insofar as they can be traded much like stocks. As a result, active traders might consider ETFs a better choice than mutual funds.
Active vs. passive
There’s also the consideration that active traders can often 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 very likely to prefer ETFs over mutual funds due to their flexibility. Meanwhile, passive investors may be able to take advantage of automatic investing plans that allow people set up regularly scheduled purchases of mutual funds; these plans are typically not offered with ETFs. So, if you’re thinking about buying ETFs, it’s really a matter of if you prefer active vs. passive investing.
In general, ETFs involve a lower turnover rate in their holdings when compared to mutual funds. This means that there will likely be fewer taxable events, and thus less tax liability for investors with ETFs than with mutual funds.
Moreover, mutual funds pay a greater portion of their net asset value (or NAV) in capital gains out to shareholders. More capital gains typically means 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 can make mutual fund investing challenging or even prohibitive for those with small accounts.
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, has low commission, and amazing customer service. Check out our top picks below.
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