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ETFs and mutual funds both pool investor money into a collection of securities, exposing investors to many different securities without having to purchase and manage them. But what are ETFs and mutual funds — and which is better?
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ETF vs. mutual fund
The main difference between ETFs and mutual funds is an ETF's price is based on the market price, and is sold only in full shares. Mutual funds, however, are sold based on dollars, so you can specify any dollar amount you'd like to invest. ETFs also tend to be cheaper than mutual funds.
» Learn more: What is an ETF?
Exchange-traded funds (ETFs) | Mutual funds | |
|---|---|---|
Cost to invest | Varies. The median price of the most popular ETFs is $44. | Varies. The median price of some of Morningstar’s top-ranked mutual funds is $54. |
Average expense ratio | 0.16%. | 0.60%, plus any additional fees. |
How to buy | Traded during regular market hours and extended hours. | At the end of the trading day after markets close. |
Security information is supplied by a variety of sources. Data is current as of July 29, 2022. | ||
ETFs vs. mutual funds: The main differences
ETFs and mutual funds are both investment vehicles that can help you save for retirement. Here are the main differences.
1. How they’re managed
Typically, mutual funds are run by a professional manager who attempts to beat the market by buying and selling stocks using their investing expertise. This is called active management, and it often translates into higher costs for investors. It can also mean worse performance, as fund managers are notoriously bad at predicting the market.
ETFs are usually passively managed funds. These funds automatically track a pre-selected index, such as the S&P 500 or the Nasdaq 100. However, there are a few actively managed ETFs, which function more like mutual funds and have higher fees as a result.
While actively managed funds may outperform ETFs in the short term, long-term results tell a different story. Between the higher expense ratios and the unlikelihood of beating the market over and over again, actively managed mutual funds often realize lower returns compared to ETFs over the long term.
» Ready to get started? See NerdWallet’s best online brokers for ETF investing.
2. Their expense ratios
An expense ratio indicates how much investors pay each year, as a percentage of the amount invested, to own a fund.
Passively managed ETFs are relatively inexpensive. Some carry expense ratios as low as 0.03%, meaning investors pay just $0.30 per year for every $1,000 they invest. This is considerably lower than actively managed funds. In 2021, the average annual expense ratio of actively managed funds was 0.60%, compared to an average of 0.12% for passively managed funds, which includes index funds.
But don’t assume ETFs are always the cheapest option on the menu. It’s worth comparing ETFs and mutual funds when considering your investment options.
» What’s the cost? Mutual fund fees investors need to know
3. How they’re traded
ETFs usually track an index, but they’re index funds with a twist: They’re traded throughout the day like stocks, with their prices based on supply and demand. On the other hand, traditional mutual funds, even those based on an index, are priced and traded at the end of each trading day.
The stock-like trading structure of ETFs also means that when you buy or sell, you might have to pay a commission. However, this is becoming increasingly uncommon as more and more major brokerages do away with commission fees. While that’s great news for ETF buyers, it’s important to remember that most brokers still require you to hold an ETF for a certain number of days, or they charge you a fee. ETFs aren’t normally intended for day-trading.
» Learn more: Everything you need to know about ETFs
4. How they’re taxed
Because of how they’re managed, ETFs are usually more tax-efficient than mutual funds. This can be important if the ETF is held within a taxable account and not within a tax-advantaged retirement account, such as an IRA or 401(k). When an investor buys an ETF, you won't pay capital gains taxes unless the shares are eventually sold for a profit.
Mutual funds, on the other hand, are structured in a way that tends to incur higher capital gains taxes. Because they’re actively managed, the assets in a mutual fund are often bought and sold more frequently. When this is for a gain, the capital gains taxes are passed on to everyone with shares in the fund, even if you’ve never sold your shares.
5. The minimum investment
Mutual funds can have high costs of entry: Even target-date mutual funds, which help novice investors save for specific goals, often have minimums of $1,000 or more. However, ETFs can be purchased by the share, lowering the cost of establishing a position or adding to an existing one.
» Compare index funds and ETFs
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ETFs vs. mutual funds: Which is best for you?
Investors shouldn’t assume that any investment is low cost. It’s always important to look under the hood at all potential fees, and that’s true for ETFs, in spite of their reputation for being inexpensive. In general, however, ETFs give investors broad market exposure, and they can still provide great diversification with minimal fees.
One last point: If you’re not a hands-on investor, you may be happier in a target-date fund, which automatically rebalances for you. Investing in ETFs means taking on that duty or outsourcing it to a financial advisor or robo-advisor.
» Want more options? See our picks for the best brokers for funds.
Learn more about sector ETFs:
How to choose the right biotech ETFs for you
Explore inflation-hedging gold ETFs
Marijuana ETFs: On a Roll or Up in Smoke?
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Invest abroad? Check out China ETFs
As an investment expert with extensive knowledge in the field, it's crucial to dissect the information provided in the article to help readers make informed decisions about ETFs and mutual funds. Here's a breakdown of the concepts used in the article:
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ETFs (Exchange-Traded Funds):
- Definition: ETFs are investment funds that are traded on stock exchanges, similar to individual stocks. They aim to track the performance of a specific index, such as the S&P 500 or Nasdaq 100.
- Management Style: ETFs are generally passively managed, automatically mirroring the performance of a predefined index. However, there are actively managed ETFs with higher fees.
- Expense Ratios: ETFs tend to have lower expense ratios compared to mutual funds, making them a cost-effective investment option.
- Trading: ETFs are traded throughout the day like stocks, and their prices are determined by supply and demand. Buyers and sellers may incur commissions, although commission fees are becoming less common.
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Mutual Funds:
- Definition: Mutual funds pool money from multiple investors to invest in a diversified portfolio of stocks, bonds, or other securities. They are actively managed by professional fund managers.
- Management Style: Mutual funds are actively managed, with fund managers making decisions to beat the market based on their expertise.
- Expense Ratios: Actively managed mutual funds generally have higher expense ratios compared to passively managed ETFs, leading to potentially higher costs for investors.
- Trading: Mutual funds are priced and traded at the end of the trading day. They are not traded throughout the day like ETFs.
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Cost to Invest:
- ETFs: The median price of popular ETFs is mentioned as $44. Expense ratios for passively managed ETFs can be as low as 0.03%.
- Mutual Funds: The median price for some of Morningstar's top-ranked mutual funds is $54. Actively managed funds may have an average expense ratio of 0.60%.
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How They're Managed:
- ETFs: Primarily passively managed, tracking a specific index. Some ETFs are actively managed, behaving more like mutual funds with higher fees.
- Mutual Funds: Actively managed by professional fund managers aiming to outperform the market.
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Expense Ratios:
- ETFs: Typically have lower expense ratios, some as low as 0.03%, making them cost-effective for investors.
- Mutual Funds: Actively managed funds often have higher expense ratios, averaging around 0.60%, leading to potentially higher costs for investors.
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How They're Traded:
- ETFs: Traded throughout the day like stocks, with prices based on supply and demand. Commission fees may apply, but they are becoming less common.
- Mutual Funds: Priced and traded at the end of the trading day.
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How They're Taxed:
- ETFs: Generally more tax-efficient due to their passive management style. Investors may not pay capital gains taxes unless they sell the shares for a profit.
- Mutual Funds: Actively managed mutual funds may incur higher capital gains taxes due to frequent buying and selling of assets within the fund.
-
Minimum Investment:
- ETFs: Can be purchased by the share, reducing the cost of entry and allowing investors to establish positions with lower amounts.
- Mutual Funds: Often have higher minimum investment requirements, sometimes exceeding $1,000.
In conclusion, both ETFs and mutual funds have their advantages and drawbacks. The choice between them depends on individual preferences, investment goals, and risk tolerance. Investors are encouraged to carefully evaluate fees, management styles, and tax implications before making investment decisions.
