ETFs vs. Mutual Funds: Understanding the Difference

Talk to one investor, and they’ll tell you that exchange-traded funds are the best investment around. Another might say that mutual funds are still the best way to make money on the stock market.

Read: 3 Things You Must Do When Your Savings Reach $50,000

Both of these investments are excellent choices — if they align with your investing strategy and risk tolerance. Deciding which one is better for you means understanding what they are and how they are similar or different.

What Is an ETF?

An exchange-traded fund is an investment pool that collectively invests in a basket of securities on behalf of shareholders. The “exchange-traded” part comes in because, like a stock, ETFs are traded on a public stock exchange. That can be good for active traders, but it might also lead some investors to make poor decisions, Fidelity warns.

ETFs are good options for investors who want diversification and professional management but who also want the ability to buy and sell shares at any time that the market is open.

What Is a Mutual Fund?

Mutual funds are professionally managed pools of investable capital contributed by shareholders, like ETFs. However, shares are sold directly to investors by the fund companies themselves, rather than trading on an open stock exchange.

There are literally thousands of mutual funds available covering any investment style imaginable. Whether you want to invest in large U.S. stocks, small foreign stocks, emerging market bonds or gold and precious metals, you can find plenty of funds to invest in.

Mutual fund prices change at the end of the trading day because share prices are based on the underlying assets’ closing prices. Trades are executed at that time.

What’s the Difference Between ETFs and Mutual Funds?

Both ETFs and mutual funds pool investors’ money to invest in portfolios of assets according to the fund’s strategy. Both also have the potential to offer diversification at lower costs, providing investors with the opportunity to access nearly any investment type.

While these investments have similarities, they also have differences. Some of the biggest differences between ETFs and mutual funds are the trading fees, taxes and flexibility.

Here is a closer look at the similarities and differences. 

Trading Costs and Expense Ratios

Many no-load mutual funds are available, and many ETFs trade for free as well, thanks to brokerage firms that have eliminated commissions on stock and ETF trades.

Generally speaking, traditional mutual funds have higher overall expense ratios than ETFs. Buying shares of a mutual fund directly from a management company involves more paperwork, which is part of the reason mutual funds cost more than their exchange-traded counterparts.

Management

Professional money managers oversee both mutual funds and ETFs.

ETFs can be actively managed, which means the manager sells or adds stocks as needed to keep the fund aligned with its investment strategy. However, most are passively managed. A passively managed fund is one that simply tracks an index rather than relying on its managers to make investment decisions.

Mutual funds are often actively managed, but they can be passively managed as well. For example, the Vanguard Total Stock Market Index Fund Admiral Shares (VTSAX) is passively managed, only requiring changes when the underlying index is changed.

Taxes

ETFs tend to be more tax-efficient than mutual funds. They’re structured to make it easier for their managers to offset gains and losses, thereby reducing the tax liability for shareholders.

Traditional mutual funds must continuously buy and sell securities to rebalance the fund. This creates taxable capital gains.

Trading Margins, Options or Shorting

ETFs are more flexible than mutual funds. You can trade ETFs on margin but can’t with mutual funds. You can also write options against ETFs or sell them short.

Holding Period Return

When you own an ETF, you earn the difference between your purchase price and your sale price on the open market, plus any dividends. With a mutual fund, you earn the actual net asset value gain or loss from the time of purchase to sale.

Disclosure

Exchange-traded funds frequently report their holdings, sometimes disclosing their entire portfolios on their company web pages. Mutual funds report their holdings quarterly or semi-annually.

Choosing Between Mutual Funds and ETFs

Your choice of investment strategies defines which type of investment you choose. Here’s a look at what you should consider when deciding between ETFs and mutual funds.

Level of Attention and Risk

ETFs generally require more attention from investors. If you prefer to be more involved in trading and trade whenever the markets are open, ETFs are excellent.

Mutual funds are excellent for making regular, automated, long-term investments.

Neither is without risk, and one isn’t riskier than the other. Both are subject to market and interest rate risks as well as risks related to the type of securities the fund invests in.

Tax Considerations

Tax-conscious investors might lean toward ETFs over mutual funds because mutual funds must make distributions of capital gains.

Initial Investment Requirements

The minimum investment in an ETF is the price of one share. As of Feb. 20, the lowest ETF shown in Fidelity’s screening tool is $0.78 per share. Depending on your broker, you might even be able to purchase fractional shares based on a dollar amount rather than a share price.

Mutual funds can also be purchased in fractional shares, but most have minimum investments of $1,000 to $3,000. However, some brokers, such as Fidelity, have funds with no minimums.

Final Thoughts

ETFs tend to have fewer fees and more flexibility than mutual funds, and you can buy a single share if you want. However, you’ll have to watch your investment closely, just like you would a stock. Mutual funds, on the other hand, can be more expensive in terms of both fees and minimum investment, but they require less attention and are more likely to be actively managed.

The best choice for you is the one that aligns with your investment preferences and wallet. Often, the fund’s securities are more important to consider than the type of fund. When you’re budgeting for a mutual fund or ETF, be sure to never invest more than you can afford to lose.

FAQ

Here are the answers to some of the most frequently asked questions about ETFs vs. mutual funds.

• Why buy an ETF instead of a mutual fund?

  • You might consider ETFs over mutual funds if you are looking for more flexibility and fewer fees.

• What are the disadvantages of ETFs?

  • ETFs might require more attention from investors, which could be a disadvantage depending on your investment preferences.

• Are mutual funds worth it over ETFs?

  • Both ETFs and mutual funds are excellent investment choices and deciding on one over the other will come down to your investment strategy and risk tolerance.

• Which is riskier: ETFs or mutual funds?

  • Both of these investments come with risk and one isn’t riskier than the other. Both are subject to interest rate risks, market risks and also risks around the type of securities the fund invests in.

John Csiszar and Daria Uhlig contributed to the reporting for this article.

Information is accurate as of Feb. 20, 2023. 

This article originally appeared on GOBankingRates.com: ETFs vs. Mutual Funds: Understanding the Difference