As you’re looking to invest, you’ll come across two major types of funds: mutual funds and exchange-traded funds. What are they and which is better?
ETFs and mutual funds both pool investor money into a collection of securities, allowing investors to diversify without having to purchase and manage individual assets. But ETFs are the darlings of the investing world right now, due in part to robo-advisors, which often use them in customer portfolios. Their growth has been rapid: In 2003, there were only 123 ETFs in the United States. In 2020, there were over 2,000.
So why have ETFs soared in popularity? In short, they offer the same diversification benefits as mutual funds, but often at a much lower cost to the investor. There are also a few more differences to understand before you choose one over the other.
One caveat to start: Below we are comparing ETFs and actively managed mutual funds, but passively managed mutual funds — commonly known as index funds — also exist. Index funds bring some of the same benefits of ETFs, but there are still some differences to note. You can compare index funds and ETFs if these vehicles are more your speed than actively managed mutual funds.
The biggest differences between mutual funds and ETFs
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.
ETFs, on the other hand, are usually passively managed funds. These funds automatically track a pre-selected index, such as the S&P 500 or the Nasdaq 100. 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.
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 2018, the average annual expense ratio of actively managed funds was 0.67%, compared to an average of 0.15% for passively managed funds, like most ETFs.
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.
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 commissions on ETF, stock, or options trades. 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.
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.
Deciding 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 are an affordable option that gives investors broad market exposure, and they can still provide you with diversification.
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.