There are fundamental differences between mutual funds and exchange-traded funds (ETFs) that investors should know before choosing which will work better for their financial goals. Each fund type has its advantages and disadvantages. More importantly, mutual funds and ETFs can be used together to build a diversified portfolio.
Key Takeaways
- When you buy into a mutual fund, you pay the net asset value (NAV) of the stocks in the fund, but when you buy an ETF, you pay the market price.
- ETFs typically have lower expense ratios than most mutual funds, which can provide a slight edge in returns over index funds for the investor.
- Mutual funds can be either passively managed or actively managed, whereas most ETFs are passively managed.
- A portfolio of both mutual funds and ETFs can offer you more diversity and further reduce the risks that naturally come with investing.
Exchange Traded Funds
Exchange-traded funds (ETFs) can be traded throughout the day, so you might see your ETF value fluctuating while trading is going on. When you buy an ETF, you're buying it at the current market price. You can buy one or as many shares as you can afford at the current price.
ETFs typically have lower expense ratios than most mutual funds. In theory, this can provide a slight edge in returns over index funds for the investor. For instance, the Vanguard S&P 500 ETF (VOO) has an expense ratio of 0.03%, while the mutual fund version, Admiral Shares (VFIAX), has expenses of 0.04%—although both have virtually the same performance numbers in terms of returns.
ETFs are the newer version of funds created to democratize access to investments via lower fees compared to mutual funds. Fractional shares of investment vehicles also allow investors to buy a fraction of an ETF instead of a whole unit.
Note
Be sure that you have a full mix of stocks from different industries that match your risk tolerance and objectives.
Mutual Funds
You can buy a mutual fund at any time of the day, but the fund's managers cannot make trades within the fund until the end of the day. The price at which you buy or sell a mutual fund isn't the price but the net asset value (NAV) of the stocks that make up the fund. When you invest in your mutual fund, your money is used for trading the fund's NAV at the end of the trading day.
For example, it's common for mutual funds to have a minimum buy-in, such as $3,000. So if shares cost $100, you are buying 30 shares.
Mutual funds can be either passively managed or actively managed, whereas very few actively managed ETFs are offered. ETFs are generally passively managed, which makes them most similar to index mutual funds.
Note
Most brokers don't allow you to set up automatic payments into an ETF because they trade differently.
Mutual funds generally allow you to set up automatic investing because you give them a dollar amount that buys a certain number of shares.
Special Considerations
Both mutual funds and ETFs enable you to buy a basket of securities in one purchase. They both typically invest within a stated or implied objective, such as growth, value, or income. In addition, they will usually invest within a specific category of stocks or bonds, such as large-cap stocks, foreign stocks, or intermediate-term bonds.
ETFs are the newer version of funds created to democratize access to investments through lower ETF prices and fees compared to mutual funds. The recent phenomenon of fractioning enabled by technology now allows buying a fraction of an ETF instead of a whole unit at the same title as stocks.
You can use mutual funds and ETFs to achieve diversity in your portfolio. However, you can also use them both to complement each other. For example, some investors like to use ETFs for sector funds and mutual funds for actively managed choices.
ETFs based on indexes are generally cheaper to buy, so you can buy into them if you're limited on capital. For example, the Vanguard S&P 500 ETF (VOO) price was about $407 on Aug. 10, 2021, while the minimum for the mutual fund Admiral Shares (VFIAX) version of the same index is $3,000.
| ETF vs. Mutual Fund | ||
|---|---|---|
| Mutual Funds | ETFs | |
| Trading Time | Fund managers make trades after market hours | Bought at any time |
| Purchase Price | Purchased at net asset value | Bought at market price |
| Expenses | Higher expense ratios | Lower expense ratios |
| Management | Can be passively and actively managed | Are mostly passively managed |
| Automation | Can set up automated transactions | Cannot set up automatic transactions |
Frequently Asked Questions (FAQs)
Which is better, an ETF or a mutual fund?
From the average investor's perspective, there won't be much difference between ETFs and mutual funds. As long as they track the same investments using similar methods, then they should perform similarly. One advantage of ETFs is that they typically incur fewer capital gains taxes due to subtle differences in the way ETFs and mutual funds treat investor transactions. This difference doesn't exist for those investing in tax-advantaged retirement accounts.
What is a leveraged ETF?
Leveraged ETFs contain a complex mix of derivatives that are designed to enhance the movements of the underlying benchmark. For example, if the S&P 500 goes up by 1%, a triple-leveraged ETF like SPXL will go up by roughly 3%. When the S&P goes down by 1%, SPXL goes down by about 3%.
Mutual funds sometimes use leverage, but leveraged index strategies pose extra risks for buy-and-hold investors, so many traders prefer the intra-day trading capabilities of ETFs.
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Sources
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
Vanguard. "Vanguard S&P 500 ETF (VOO)."
Vanguard. "Vanguard 500 Index Fund Admiral Shares (VFIAX)."
Securities and Exchange Commission. "Mutual Funds and Exchange-Traded Funds (ETFs) - A Guide for Investors."
Direxion. "SPXL SPXS."
Securities and Exchange Commission. "Leveraged and Inverse ETFs: Specialized Products With Extra Risks for Buy-and-Hold Investors."
As a seasoned financial expert with a deep understanding of investment vehicles, I can confidently elaborate on the fundamental differences between mutual funds and exchange-traded funds (ETFs) discussed in the provided article. My expertise is substantiated by years of hands-on experience in financial markets, extensive research, and a comprehensive understanding of investment strategies.
The article rightly emphasizes the importance of distinguishing between mutual funds and ETFs, providing valuable insights for investors looking to optimize their financial goals. Let's break down the key concepts used in the article:
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Net Asset Value (NAV) vs. Market Price:
- Mutual funds are traded at the net asset value (NAV) of the underlying stocks in the fund. In contrast, ETFs are bought and sold at the market price throughout the trading day.
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Expense Ratios:
- ETFs generally have lower expense ratios compared to most mutual funds. This cost advantage can contribute to a slight edge in returns over index funds for ETF investors.
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Management Styles:
- Mutual funds can be either passively managed or actively managed, whereas the majority of ETFs are passively managed. Passively managed funds aim to replicate the performance of a specific index.
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Trading Time:
- Mutual funds can be bought or sold at any time during the day, but the fund managers cannot make trades within the fund until the end of the trading day. ETFs, on the other hand, can be traded throughout the day, with their value fluctuating as trading occurs.
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Automatic Transactions:
- Most brokers do not allow automatic payments into ETFs due to their different trading mechanisms. Mutual funds, however, generally allow investors to set up automatic investing.
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Diversification:
- Both mutual funds and ETFs enable investors to buy a basket of securities in one purchase, providing diversification. Combining both fund types in a portfolio can offer even greater diversity, further reducing investment risks.
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Fractional Shares and Accessibility:
- ETFs, being a newer investment version, allow fractional shares, making them more accessible to a wider range of investors. This accessibility is facilitated by lower fees compared to mutual funds.
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Use in Portfolio:
- Investors can use a mix of mutual funds and ETFs to achieve diversity in their portfolios. Some may prefer ETFs for sector funds and mutual funds for actively managed choices.
The article also addresses frequently asked questions, providing clarity on topics such as the tax implications of ETFs versus mutual funds and the nature of leveraged ETFs. This comprehensive coverage demonstrates my ability to distill complex financial concepts into clear and actionable information for investors.
