Investing is a topic that encompasses a wide range of assets. Rather than investing in individual stocks, bonds, or other assets, many investors turn to investment-grade funds to give them diversified exposure to the market.
If this is the path for you, your biggest choice will be deciding between exchange-traded funds (ETFs) and mutual funds.
Which is the better option? Well, that depends on what you’re looking for in an investment. Here’s the breakdown:
ETFs vs. Mutual Funds – 6 Differences Between Them
ETFs and mutual funds are similar in many ways. They are both bucket investments that pool money from a large group of investors to purchase stocks, bonds, and sometimes more exotic assets on behalf of the fund’s investors.
When the fund gains in value, its participants realize gains based on the amount of money invested as shares of the total net asset value (NAV) of the fund.
However, that’s where similarities stop. When it comes to fees, tax efficiency, asset management, diversification, asset allocation, initial investments required, and liquidity, ETFs and mutual funds are significantly different from one another.
1. Cost
Regardless of how you invest, you’re going to have to pay fees. When it comes to these funds, management fees are generally displayed to the public as expense ratios, which represent the percentage of the investment you’ll pay during the average year.
Here’s what to expect when it comes to expense ratios you’ll be charged with each option:
ETF Fees
ETFs are the low-cost option between the two. According to the Wall Street Journal, the average expense ratio charged on an ETF currently sits at 0.44%. At that rate, if you have $10,000 invested, you’ll pay $44 per year to invest in the average ETF.
However, as with any product, it’s important to do your research. Some providers, including Vanguard and Fidelity, charge significantly lower fees, some of which are as low as 0.05%, while others are known for charging fees that clock in far higher than the industry average.
ETFs are the clear winner in terms of transaction fees. The cost of the transaction to buy or sell ETF shares is usually the same as domestic stock trades. With the rise of zero-commission brokers, the fees to buy and sell these funds have largely been eliminated.
Mutual Fund Fees
Mutual funds, on the other hand, are generally exempt from the zero-commission rule at most discount brokers. The average brokerage charges around $30 for mutual fund transactions (buying or selling shares), adding to the overall cost of the investment.
Mutual fund pricing for shareholders works the same, in that it is presented to investors as an expense ratio. However, these funds tend to come with a much higher cost. According to a research report by the Investing Company Institute, the average mutual fund expense ratio in 2020 was 0.71%, down from 1.08% in 1996.
While these funds have seen a large reduction in cost over the past couple of decades, they are still significantly more expensive than ETFs, but there’s a reason for that. Most exchange-traded funds are passively managed, while most mutual funds are actively managed. The increased cost ultimately relates to the increased amount of work involved in managing the assets held in the fund.
2. Tax Efficiency
If you’re making money in the United States, the IRS wants to know, and they want their cut. That’s the case when you clock in at work, start a business, sell a car, or even decide to invest.
The IRS looks at investments differently depending on the amount of time they’re held.
Gains in the stock market are charged either at the capital gains tax rate or the standard income tax rate. Investments that are held for less than one year are taxed at the standard income tax rate, while those held for a year or longer are taxed at a lower capital gains rate.
One of the key differences between the two types of investment funds is how the money you make will be taxed.
ETF Tax Efficiency
Not only are ETFs the lower-cost option, they are also the more tax-efficient type of fund.
Being passively managed, assets in ETFs are rarely traded. Trades only take place when an underlying benchmark changes its listings. Therefore, the vast majority of assets held in an ETF will generally be held for longer than one year, meaning that when assets are finally sold, you’ll pay a lower rate when reporting the income to the IRS.
Mutual Fund Tax Efficiency
Mutual funds are generally actively managed, which means that trades happen on a regular basis. Depending on the investment objectives and investment strategy laid out in the prospectus for the fund, multiple trades may happen within a mutual fund in the course of a single trading day.
As a result, investments in mutual funds are considered to be short-term in most cases, meaning they’re held for less than a year. Short-term gains generated through these funds are taxed at your standard income tax rate. Depending on your income tax bracket, the difference has the potential to be quite extreme, so ETFs may be the better option for high-income earners.
3. Asset Management
The two different types of funds are managed in two different ways — either passively or actively — but what exactly does that mean?
ETF Asset Management
The vast majority of these funds are passively managed. Many ETFs, especially index funds, work to track the returns of an underlying market index, also known as a benchmark index. That means they invest in the same assets held by the index in an attempt to mirror its returns.
For example, an S&P 500 index fund would invest in every stock listed on the S&P 500 in an attempt to generate returns for investors that are equal to the returns generated by the index. The only time trades will take place inside the fund is when the S&P 500 changes the constituents of its index, in which case, whatever stocks were dropped from the index will be removed from the fund’s holdings, while stocks added to the index will be purchased to replace them.
Mutual Fund Asset Management
Mutual funds are managed differently. Most of them are actively managed, meaning that the fund manager is consistently looking for ways to increase the value of the fund. As a result, the majority of investments are cashed out within the first year, and some within a single trading session.
Rather than following a strategy to mimic an underlying index, these funds follow strategies like growth, income, value, and factoring to generate the largest return possible. These funds aim to beat average market returns, attempting to outpace the returns of their exchange-traded counterparts.
4. Diversification & Asset Allocation
In general, most investment-grade funds are heavily diversified, investing in a wide range of assets to generate strong returns for their shareholders. Some will include a diversified list of stocks, bonds, or a mix of the two, while others will offer a wider range of asset classes with a lean toward commodities or real estate. Nonetheless, there is one small difference to consider:
ETF Diversification & Asset Allocation
ETF diversification is based on the diversification of the underlying index. For example, an S&P 500 fund would likely include a mix of the 500 stocks listed on the index, while a Nasdaq Composite fund would consist of more than 3,300 stocks.
There are also a long line of themed ETFs that invest in a specific sector or asset in an attempt to track its gains. For example, if you’re interested in investing in small-cap technology companies, you can find an ETF centered around these investments. Keep in mind, funds that are focused on themes rather than the broader market are generally less diversified than funds that track an entire index.
Mutual Fund Diversification & Asset Allocation
Mutual funds are well diversified, but aren’t commonly as heavily diversified as ETFs. These actively managed funds require a team to look over them and make sure the holdings follow along the lines of the investment strategy. Unless the fund is algorithmically managed, the manpower it would take to actively monitor and trade 3,000 — or even 500 — stocks would be daunting.
So, these portfolios, while diversified, are typically less diversified than their exchange-traded counterparts.
5. Initial Investment
The initial investment required to get involved in a fund is an important consideration, particularly for new investors. Here are the differences between the two options:
ETF Initial Investment
ETFs are highly accessible, with the initial investment being the market price of a single share. For example, the Vanguard Small-Cap Index Fund ETF (VB) has a share price of around $108. So, with a minimum investment of $108, you’re able to buy a share and get involved. There are countless other ETFs to choose from, including many with share prices that are much lower, meaning any investor can get started with virtually any amount of money.
Mutual Fund Initial Investment
Mutual funds are less accessible for newcomers. Some low-cost options come with a minimum investment of $500, but most have minimum investments in the thousands of dollars.
For example, at Vanguard, investors have to pony up between $1,000 and $100,000 to invest in actively managed mutual funds, with the size of the minimum required investment relating to how actively managed the fund is and the types of shares it holds.
6. Liquidity
Liquidity should always be considered, regardless of the type of investment you’re making. You don’t want to be ready to liquidate your investment only to find that it’s going to take weeks or months to get your money back. Here’s how the two types of funds stack up:
ETF Liquidity
In general, ETF liquidity is relatively strong, meaning that when it’s time to sell shares, you should be able to do so right away. However, the liquidity of an ETF is based on supply and demand in the market, with more popular funds being more liquid than lesser-known, thinly traded ones.
When investing in these types of funds, it’s important to consider both the size and average trading volume of the fund before diving in. Beginners in particular should only invest in funds that are known for high trading volumes and with a net asset value of $1 billion or higher to avoid liquidity issues.
Mutual Fund Liquidity
Mutual funds are highly liquid assets. That’s because most of these funds keep between 3% and 5% of their total assets in cash to buy back shares when an investor chooses to exit their position.
Because these funds are not traded on major stock exchanges, buy and sell orders are generally only executed once per day.
The Verdict: Should You Choose ETFs or Mutual Funds?
Which type of fund you should choose largely depends on you and your unique goals, capital availability, and risk tolerance.
You Should Invest In ETFs If…
ETFs are a better fit if you’re a new investor with a relatively small investment account and a low tolerance for risk. Consider choosing ETFs if:
- You’re a Beginner With a Low Account Balance. As a beginner, it’s hard to consider investing in an asset that requires a minimum investment of thousands of dollars. It’s more practical for you to invest in funds that you can jump into for $100 or less.
- You’re Risk-Averse. ETFs are the way to go if you’re not as into beating the market as you’re into making sure your money is growing safely. If the idea of making short-term trades scares you because you know that it’s impossible to be right 100% of the time, ETFs provide the long-term investing strategy you’re looking for.
- You’re Looking for Low-Cost Options. Because ETFs usually trade commission-free and offer low—sometimes extremely low—expense ratios, they are the top choice among cost-conscious investors. ETFs are one of the lowest-cost investing options around.
- You Prefer a Long-Term, Passive Investment. There are several different types of ETFs out there. Some focus on indexes that target a broad market and some focus on specific areas of interest or long-term themes. Investors who want to follow a specific long-term investment strategy but aren’t interested in active management trying to pick today’s winners and losers will prefer ETFs.
You Should Invest In Mutual Funds If…
Mutual funds are a better fit if you’re an aggressive investor who’s willing to pay higher fees to get more bang for your buck. If you live on the wild side, and increased risk for a larger earning potential lights your candle, mutual funds may be the way to go. Consider mutual funds over ETFs if:
- You Have More Money to Invest. You’ll likely have to shell out thousands of dollars to swim in the mutual fund pool, and the transaction fees add a modest cost to getting in or out. These funds are designed for investors who have a sizable investment account.
- You Can Tolerate Risk for Greater Rewards. The buy-and-hold strategy often deployed by ETFs is a safe way to go, but that’s not enough for every type of investor. Mutual funds cater to investors who are willing to take on bigger risks in return for bigger potential rewards.
- You Don’t Mind Paying for Expertise. Mutual fund investors know there’s value in having the pros actively manage their money, and they don’t mind ponying up when it comes time to do so.
- You Want to Beat the Market. You can’t beat the market if you become the market, and mutual fund investors want to make as much money as possible. The active trading that takes part inside these funds is attractive because it gives investors the potential to earn more than benchmark averages.
Both Are Great If…
Both ETFs and mutual funds are excellent options if you have a sizable investment account and don’t mind taking risk, but also want to mix in heavy diversification for added safety. You might be the perfect candidate to invest in both options if:
- You Have Moderate Risk Tolerance. Lots of investors are interested in beating the market but are not willing to invest all their money in an actively traded account, no matter who’s leading the portfolio. Investing in both types of funds lets you take advantage of the higher earnings potential of mutual funds while adding safety and cost effectiveness with highly diversified, long-term ETF investments.
- You Have Enough Money to Invest in Both. Keep in mind that investing in mutual funds will require initial investments of thousands of dollars. Mixing in ETFs at a similar rate would mean that you would need a relatively hefty account balance in order to invest in both options.
Final Word
All told, ETFs and mutual funds may seem to be similar assets, but when you dive into the details, you’ll quickly realize that they’re two different beasts. One, the ETF, is designed to capture returns of a specific sector or the market as a whole. The other, the mutual fund, was designed to give investors a way to beat market averages.
Regardless of which option you choose, it’s important to keep in mind that not all investments are created equal. Like any other product, it is up to the fund’s management to determine how assets will be invested, the cost associated with investing in the fund, and the different moves the fund will make over time. It’s important to do your research to get an understanding of just what you can expect from your investment before shelling out your hard-earned cash.
