ETF vs. mutual funds - Are ETFs better than mutual funds?
Updated: September 06, 2024
New investors may be tempted to confuse exchange traded funds (ETFs) with mutual funds, and it’s easy to see why. Both allow investors to pool their money into a diversified portfolio of stocks, bonds, or other assets.
But that’s where the common ground crumbles. These two investment vehicles differ significantly in how they’re traded, managed and structured, and they suit very different types of investors.
ETFs trade like stocks throughout the day, offering flexibility, while mutual funds are bought or sold at the end of the day at a set price. Their differences don’t end there, and deciding which is better for you depends on your goals, risk tolerance and whether you prefer hands-on control or professional management.
ETFs explained
ETFs, or exchange-traded funds, are investment vehicles that trade on stock exchanges, similar to individual stocks. ETFs hold a portfolio of assets such as stocks, bonds, or commodities, providing investors with exposure to various markets or sectors. A unique feature of ETFs is their ability to be traded throughout the day at market prices, allowing investors flexibility to buy and sell in real-time. ETFs are typically passively managed, tracking a specific index or sector, although actively managed ETFs are also available.
Why invest in ETFs?
Investors like ETFs for their low costs, flexibility and tax efficiency. They provide diversification with lower expense ratios than mutual funds, allowing investors to cost-effectively get broad market exposure. Additionally, ETFs are tax-efficient due to their structure, which minimizes capital gains taxes.
ETF market risks to watch out for
Despite the benefits, ETFs carry risks, including market volatility and liquidity risks1. ETFs also face tracking errors, where they may not perfectly replicate the performance of the benchmark index, affecting returns.
Best for investors needing to diversify
ETFs are ideal for investors seeking flexibility, low-cost diversification and tax efficiency. They appeal to active investors and those who prefer real-time control over their trades. Younger investors, or those starting out, often choose ETFs for their ease of use and low entry cost.
Where to buy ETFs
ETFs are available through most brokerage platforms, including Vanguard and Fidelity. Many online brokerages offer commission-free ETF trading, making them accessible to investors of all sizes. Robo-advisors, such as Betterment and Wealthfront, also offer ETF portfolios for automated investing. Investors can buy ETFs through financial advisors or directly from the fund providers, but brokerage accounts are typically the most common route.
Looking for no-commision trades on ETF shares, consider discount broker tastytrade. Investors can buy or sell multiple asset classes through ETFs with the tastytrade platform, and watchlists keep traders updated on dividend payouts and more.
Mutual funds explained
Mutual funds are professionally managed investment vehicles that pool money from multiple investors to buy a diversified portfolio of assets. Unlike ETFs, mutual funds do not trade throughout the day. Instead, they are bought and sold at the net asset value (NAV), which is calculated at the end of the trading day. Mutual funds come in two varieties: Actively managed, where fund managers aim to outperform the market, and passively managed, where the fund tracks a specific index.
Why invest in mutual funds?
Mutual funds offer professional management, making them attractive for investors who prefer a hands-off approach. Actively managed mutual funds provide the potential for outperforming the market, while passively managed mutual funds offer broad market exposure, similar to ETFs.
Mutual fund risks to watch out for
Mutual funds come with risks such as market volatility, higher fees due to active management and the potential for underperformance. Additionally, mutual funds are less tax-efficient than ETFs because of capital gains distributions that can occur even if the investor doesn’t sell their shares.
Best for investors with a long horizon
There’s a reason why nearly all employer-sponsored 401(k) plans feature mutual funds as the anchor of their offerings. They are best suited for long-term investors seeking professional management, appealing to those looking for a structured investment strategy – typically retirement investors who value a passive approach with moderate risk tolerance.
Where to buy mutual funds
Mutual funds are commonly purchased directly from fund companies like Vanguard, Fidelity and T. Rowe Price, or via any number of platforms emerging in the investment app space. They can also be bought through brokerage firms and retirement accounts such as 401(k)s or IRAs.
Microinvesting in mutual funds is simple, easy and fun with Acorns, a savings app that collects the loose change from everyday purchases and puts it to work in the market.
Interactive Brokers offers low trading fees and robust trading tools, allowing DIY investors access to 43,000-plus mutual funds from more than 600 fund families.
ETF vs mutual funds
ETFs and mutual funds both provide diversification but differ in how they are structured and traded. ETFs are traded like stocks throughout the day, while mutual funds are only traded at the end of the day at the net asset value (NAV). ETFs tend to have lower expense ratios and better tax efficiency, while mutual funds offer the benefit of professional management, especially in actively managed funds.
| Feature | ETF | Mutual funds |
|---|---|---|
| Fees | Lower expense ratios, especially for passive funds | Higher fees due to active management |
| Trading flexibility | Traded throughout the day, like stocks | Traded once per day at their net asset value (NAV) |
| Tax efficiency | More tax-efficient due to in-kind transactions | Less tax-efficient due to capital gains distributions |
| Professional management | Usually passive; some actively managed ETFs exist | Actively managed funds offer professional management |
| Liquidity | High liquidity with real-time trades | Lower liquidity, limited to end-of-day trades |
When are ETFs better than mutual funds?
Mutual funds are better suited for long-term investors seeking professional management. They are ideal for retirement accounts like 401(k)s, where regular contributions build long-term wealth. Actively managed mutual funds are a good choice for investors who believe in the expertise of fund managers to outperform the market. Mutual funds also offer a structured investment vehicle for investors with higher risk tolerance who are comfortable paying higher fees for potential outperformance.
Pros and cons of ETFs
ETFs are traded like stocks, allowing for real-time buying and selling throughout the trading day. ETFs generally have lower expense ratios compared to mutual funds, making them a popular choice for cost-conscious investors. Additionally, ETFs are known for their tax efficiency, as their structure minimizes capital gains taxes until the investor sells their shares.
ETFs do have some drawbacks. Many lack professional management, which may not appeal to investors seeking active strategies. Additionally, ETFs can be subject to tracking errors, where the fund doesn’t perfectly mirror its underlying index, and they remain vulnerable to market volatility. Despite these challenges, ETFs are a great option for investors looking for low-cost, flexible, and diversified exposure to the markets.
Pros
-
Low expense ratios
-
Tax-efficient structure
-
Real-time trading flexibility
Cons
-
No professional management (in most cases)
-
Potential for tracking errors
-
Susceptible to market volatility
When are mutual funds better than ETFs?
Retirement investors, such as those contributing to a 401(k) or IRA, often find mutual funds advantageous because they offer structured growth over time, with fund managers actively making investment decisions on their behalf. This is particularly appealing for investors in their 40s, 50s or older, who may prioritize stability and a diversified approach to growing their retirement nest egg.
Mutual funds are also well-suited for those who seek out specific investment strategies, such as actively managed funds that aim to outperform the market. While ETFs typically follow a passive, index-tracking approach, mutual funds offer a more tailored investment strategy that can cater to those willing to pay higher fees for potentially higher returns. They are ideal for those with moderate to high risk tolerance looking to leverage the expertise of seasoned fund managers.
Pros and cons of mutual funds
Mutual funds are a popular choice for long-term investors seeking professional management and structured growth. These funds pool money from many investors to create a diversified portfolio, which is actively managed by professionals aiming to outperform the market. Mutual funds are particularly appealing for retirement investors, as they offer stability and the expertise of seasoned fund managers who adjust portfolios to match specific investment goals.
However, mutual funds tend to have higher fees compared to ETFs, especially in actively managed funds, which can eat into returns. They also tend to be less tax-efficient, due to capital gains distributions. Additionally, mutual funds are traded only once per day, limiting flexibility for investors who want to react quickly to market changes. Despite these drawbacks, mutual funds remain a solid choice for those with long-term growth strategies.
Pros
-
Professional management
-
Suitable for long-term growth
-
Ideal for retirement accounts
Cons
-
Higher fees, especially for active funds
-
Less tax-efficient
-
Traded only at the end of the day
ETFs vs. mutual funds: Minimum investments
One key difference between ETFs and mutual funds is the minimum investment required to get started. ETFs are generally more accessible, as they often don’t have minimum investment requirements beyond the cost of a single share. This makes ETFs a favorable option for new or budget-conscious investors who may want to begin investing with smaller amounts of capital. For example, if an ETF’s share price is $100, an investor can start with just that amount.
On the other hand, mutual funds often come with higher minimum investments, which can range from $500 to $3,000, or more. For those just starting out or with limited funds, this can be a barrier to entry, making mutual funds less accessible compared to ETFs. But mutual fund providers will sometimes waive these minimums for investors who commit to automatic monthly contributions.
FAQs
Chris Clark is freelance contributor with MoneyWise, based in Kansas City, Mo. He has written for numerous publications and spent 18 years as a reporter and editor with The Associated Press.
Latest Articles
Disclaimer
The content provided on Moneywise is information to help users become financially literate. It is neither tax nor legal advice, is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. Tax, investment and all other decisions should be made, as appropriate, only with guidance from a qualified professional. We make no representation or warranty of any kind, either express or implied, with respect to the data provided, the timeliness thereof, the results to be obtained by the use thereof or any other matter. Advertisers are not responsible for the content of this site, including any editorials or reviews that may appear on this site. For complete and current information on any advertiser product, please visit their website.