ETFs vs. Mutual Funds: How They Differ and Which to Choose

Exchange-traded funds, known as ETFs, and mutual funds are two of the most popular ways to invest. Both let you own a diversified basket of investments with a single purchase, making them ideal for building a portfolio without picking individual stocks or bonds. But they differ in how they’re bought and sold, their costs, minimums and tax efficiency. Understanding these differences can help you choose the right option for your goals.

What they have in common

Both ETFs and mutual funds pool money from many investors to buy a collection of stocks, bonds or other assets. When you invest in either, you own a share of the fund, which gives you exposure to all of its underlying investments.

This pooling provides instant diversification. A single fund might hold hundreds or thousands of different securities, spreading your risk far more than you could easily achieve by buying individual investments yourself.

Both can be actively managed, where professional managers select investments in an attempt to outperform the market, or passively managed, where the fund simply tracks a market index, such as the S&P 500 or a total stock market index. Passively managed index funds have grown enormously in popularity because of their low costs and broad diversification.

Both are regulated by the Securities and Exchange Commission and must provide a prospectus describing their investments, objectives, risks and costs.

How they trade

The biggest difference between ETFs and mutual funds is how they’re bought and sold.

ETFs trade on stock exchanges throughout the trading day, just like individual stocks. Their prices change continuously during market hours based on supply and demand. You can buy or sell an ETF at any time the market is open, and you can use various order types, such as limit orders, which specify the price you’re willing to pay.

Mutual funds are bought and sold once a day, at a price calculated after the market closes, called the net asset value, or NAV. The NAV reflects the value of all the fund’s holdings divided by the number of shares. Whether you place an order in the morning or afternoon, you receive the same price, determined at the end of the trading day.

For long-term investors, the ability to trade during the day usually doesn’t matter much. In fact, frequent trading can lead to costly mistakes. But some investors appreciate the flexibility and price transparency of ETFs.

Minimums and costs

Some mutual funds have minimum initial investments, which may range from nothing to several thousand dollars, though many brokers offer funds with low or no minimums. ETFs can often be bought for the price of a single share, or even less if your broker offers fractional shares, making them accessible with small amounts of money.

Both ETFs and mutual funds charge an expense ratio, an annual fee expressed as a percentage of your investment, which covers the fund’s operating costs. Index funds of either type tend to have much lower expense ratios than actively managed funds. Many broad market index ETFs and index mutual funds charge very low fees.

Some mutual funds charge sales loads, commissions paid when you buy or sell shares, as well as 12b-1 marketing fees. ETFs generally don’t have sales loads, though you may pay a commission to trade them at some brokers, and you may face a small cost from the bid-ask spread, the difference between the buying and selling price.

Taxes

Because of how they’re structured, ETFs often distribute fewer capital gains to shareholders than mutual funds, which can make them more tax-efficient in taxable accounts.

Mutual funds may need to sell securities to meet shareholder redemptions, which can generate capital gains that are distributed to all shareholders, who then owe taxes even if they didn’t sell any shares themselves. ETFs typically use a process called in-kind creation and redemption, which allows them to manage capital gains more efficiently.

In tax-advantaged accounts like IRAs and 401(k)s, this difference matters less, since gains within those accounts aren’t taxed annually.

Automatic investing

Mutual funds traditionally made automatic investing easy, allowing investors to set up regular purchases of a fixed dollar amount. Many brokers now offer automatic investing and fractional shares for ETFs as well, narrowing this difference.

Which should you choose?

Both ETFs and mutual funds can be excellent choices. Many investors care more about choosing low-cost, diversified funds than about the specific wrapper. A low-cost index mutual fund and a low-cost index ETF tracking the same index will typically produce very similar results.

ETFs may appeal to investors who want low minimums, intraday trading flexibility or greater tax efficiency in taxable accounts. Mutual funds may appeal to investors who prefer simple automatic investing in exact dollar amounts or who want access to specific funds only available in mutual fund form.

Your workplace retirement plan may offer only mutual funds, which is perfectly fine. Focus on choosing low-cost, diversified options within your plan.

Questions to ask before investing

Before investing in any fund, consider what it invests in and whether that matches your goals, its expense ratio and other costs, whether it’s actively or passively managed, its performance relative to its benchmark over time and how it fits with your other investments. Reading the fund’s prospectus and fact sheet can answer many of these questions.

This article is for education only and isn’t investment advice.