For the average investor, mutual funds and ETFs seem interchangeable. They are the fundamental building blocks that their financial advisor uses to build investment portfolios. But most advisors know that while there are some similarities, mutual funds and ETFs have some notable differences, which means that, depending on the investor need and situation, one or the other might be a more suitable choice.
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Demystifying Mutual Funds vs. ETFs
Mutual funds are pools of shareholder assets that invest in securities like stocks, bonds, money market instruments, and other assets. They feature a stated investment objective and risk profile and are professionally managed. Managers allocate the fund's assets with the goals of producing returns — and consequently capital gains or income — for investors.
Mutual funds are widely accessible to retail investors for relatively low investment minimums and give investors access to professionally managed portfolios of equities, bonds, and other securities. Mutual funds invest in a vast number of securities, and performance is usually tracked as the change in the total market cap of the fund — derived by the aggregating performance of the underlying investments. Shareholders participate in the gains or losses of the fund.
Exchange-Traded Funds, or ETFs, are single securities that typically mirror and track an index or other portfolio with the goal of achieving similar returns for investors. ETFs are relatively new in the investing ecosystem, first introduced in 1993.¹ Since then, they have grown in popularity due to their lower costs, increased tax efficiency, and transparency within portfolios.
While ETFs continue to grow in numbers and assets, mutual funds still amount to more than double ETFs:
- In 2021, there were roughly 2,500 ETFs compared to around 6,300 mutual funds.²
- Flows from 2020 to August 2021, were $1.1 trillion into ETFs compared to $24 billion in mutual funds.²
- In 2022, total ETF assets were $6.4 trillion³ compared to $27 trillion in mutual fund assets⁴
- Combined, more than 62 million American households are invested in them, most of those with the goal of saving for retirement.⁴
These portfolio building blocks are so popular because they are plentiful, easily accessible, and offer investors the benefits of diversification and professional money management.
Spot the Differences
While they both provide benefits for investors, mutual funds and ETFs are not interchangeable. There are significant differences in the ways they are managed, how they are priced and their expense ratios, and how they are purchased and redeemed. Let’s take a look at some of their differences.
Investment Approach
Mutual funds are either actively managed or passively managed, such as index funds. Funds that are actively managed aim to outperform a benchmark index. Index funds mirror the holdings of a specific index and strive to replicate the performance of that index. ETFs are often associated with passive management because many of them track well-known indices, but they can be either actively managed or passively managed, similar to mutual funds.
Pricing
Mutual funds are purchased at a price based on its net asset value (NAV), calculated daily after the markets close. Anyone buying or selling shares of a fund on any particular day get the same price. Similar to stocks, ETFs are priced throughout the trading day. ETFs have a NAV each day, but the market price for an ETF can fluctuate based on supply and demand factors.
Trading
Mutual funds are generally bought and sold through the fund company at the end-of-day net asset value (NAV) price. Orders to buy and sell shares can be placed throughout the trading day, but the actual transactions occur at the close of the trading day when the NAV is struck. ETFs are traded on stock exchanges just like individual stocks, which means ETFs can be bought and sold throughout the trading day at market prices. ETFs offer more intraday liquidity compared to mutual funds.
Buying and Selling
Mutual funds issue and redeem shares directly with the fund company. When investors buy mutual fund shares, the fund company creates new shares. When investors sell shares, the company redeems those shares. ETFs are created and redeemed by authorized participants, typically large financial institutions. These institutions exchange a basket of assets, such as stocks, for shares of the ETF, which helps keep the ETF's market price close to its NAV.
Transparency
In most cases, mutual funds disclose their holdings on a quarterly basis, albeit with a time lag. Investors don't know the fund's exact holdings in real-time. ETFs are generally more transparent because they usually disclose their holdings on a daily basis, giving investors insight into exactly what assets the ETF holds on any given trading day.
Minimum Investment Amounts
Mutual funds may have minimum investment requirements that vary from fund to fund. ETFs do not typically have minimum investment requirements, allowing investors to buy as few or as many shares as they want.
Tax Efficiency
When a mutual fund manager buys or sells securities within the fund, they may generate capital gains taxes, which are passed along to shareholders. ETFs are generally more tax-efficient in that they tend to generate fewer capital gains, creating less of a tax burden for investors.
Here’s a quick comparison chart:
Mutual Funds vs. ETFs: A Quick Comparison
| Mutual Funds | ETFs | |
|---|---|---|
| Diversification | Yes | Yes |
| Professionally managed | Yes | Yes |
| Active or passive investing approach | Mostly active (depends on the fund) |
Mostly passive (depends on the ETF) |
| Priced | Daily NAV after market close | Intraday pricing |
| Daily transparency of holdings | No | Yes |
| Minimum investment amounts | Yes | No |
| Tax-efficiency | Depends on the fund but generally less tax-efficient | Depends on the ETF but generally more tax-efficient |
Meeting Investor Objectives
Both mutual funds and ETFs have their advantages and disadvantages, and the choice between them depends on various factors. Let’s take a look at investor objectives and which type might be more suitable.
Objective: Active Management
Mutual funds are managed by professional portfolio managers who make investment decisions on behalf of the investors of the fund. For anyone wanting a hands-off approach or doesn’t want to manage their own investments, this expertise can be valuable.
Objective: Increased Tax-Efficiency
ETFs tend to generate fewer capital gains distributions, making them more tax-efficient than mutual funds.
Objective: Dollar-Cost Averaging
Mutual funds are well-suited for investors looking to implement a dollar-cost averaging strategy because they allow for automatic investments at pre-determined intervals. This makes it easy to implement and maintain a DCA strategy.
Objective: Automatic Reinvestment
Investors who want to automatically reinvest dividends and capital gains distributions should consider mutual funds for an easy and seamless way to execute this.
Objective: Transparent Access to Holdings
ETFs provide real-time pricing and intraday liquidity, allowing investors to know the market value of their holdings at any moment. This transparency can be attractive to those who want to closely monitor their investments.
Objective: Keep Expenses Low
When compared to actively managed mutual funds, ETFs often have lower expense ratios compared to actively managed mutual funds, which can result in lower ongoing costs for investors over the long term.
Objective: Avoid Trading Costs
Buying and selling mutual fund shares typically does not involve commissions, which makes them cost-effective, especially for investors who want to make frequent contributions without incurring additional fees.
Objective: Diversification for Long-Term Goals
Mutual funds are often chosen for long-term investment goals, such as retirement planning or saving for a child's education, as they can provide diversified exposure to various asset classes over time.
Objective: Invest in Specific Strategies
ETFs are available for a wide range of investment strategies, including sector-focused, thematic, and leveraged/inverse products. For investors who want exposure to a particular sector or asset class, ETFs offer a diverse array of options.
Comparing Pros and Cons
The choice between mutual funds and ETFs depends on an investor’s goals, risk tolerance, trading frequency, and other individual factors. Some investors also choose to use a combination of both mutual funds and ETFs to create a diversified portfolio that aligns with their financial objectives and preferences. There are pros and cons associated with each.
Mutual Funds: Pros
- Choice of investing in passively managed and actively managed funds
- Professional fund manager actively managing and rebalancing in response to big-picture economic fundamentals
- Direct automatic purchases
Mutual Funds: Cons
- Higher turnovers which can mean more transaction costs and a larger capital gains tax bill
- Fund managers only report their holdings quarterly or semiannually
- Mutual fund holders may also pay 12b-1 fees that are part of a fund’s operating expenses
ETFs: Pros
- Flexibility of intraday trading
- Lower (or none) minimum investment requirements
- Tax efficiency with less capital gains daily holding disclosures
ETFs: Cons
- Generally less active management
- May require additional time and effort
- Multiple trades can be subject to intraday volatility
Mutual funds and ETFs are similar as both provide a means to invest in pooled assets, both are professionally managed, and both offer a convenient way to achieve diversification. Knowing which might be better for serving client financial goals, meeting their risk tolerance or aligning with their investment preferences depends on each individual client circumstances.
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