What is the difference between exchange-traded funds and mutual funds?
Exchange-traded funds, or ETFs, are similar to mutual funds because both instruments bundle together securities to offer investors diversified portfolios. Typically anywhere from 100 to 3,000 different securities can make up a fund. Yet, the two investment types are marked by significant differences.
ETFs trade throughout the trading day, like stocks, while mutual funds trade only at the end of the day at the net asset value (NAV) price. Most ETFs track a particular index and as a result have lower operating expenses than actively-invested mutual funds. Thus, ETFs may improve your rate of return on investments. In addition, ETFs have no investment minimums or sales loads, unlike traditional mutual funds, which often have both. Most indexed mutual funds, however, will not have sales loads.
Taxes and Rate of Return
ETFs create and redeem shares with in-kind transactions that are not considered sales. Thus, taxable events are not triggered. Redemptions create tax events in mutual funds, but they do not create tax events in ETFs. When a forced sale of stock occurs, mutual funds record and distribute higher levels of capital gains than ETFs.
In addition, ETFs have greater tax efficiency due to a structure that allows them to substantially decrease or avoid capital gains distributions altogether. This difference can greatly affect the overall rate of return, even if an ETF and mutual fund both track the identical index.
|Trade during trading day||Trade at closing NAV|
|Low operating expenses||Operating expenses vary|
|No investment minimums||Most have investment minimums|
|No sales loads||May have sales load|
An exchange traded fund, or ETF, is very similar to a mutual fund for many practical purposes but has advantages that mutual funds do not. Like a mutual fund, it can be a passive, broad indexed fund like an S&P 500 Fund, or it can be a sector fund. Both can also be actively managed where they have more flexibility on individual asset selection. Thus both can invest in indices, sectors, bonds, commodities, currencies, real estate, precious metals, or even be actively managed.
The main difference is that ETFs trade during the day like a stock whereas a mutual fund can only be bought or sold at the net asset value, or NAV, at the end of the day. Therefore, ETFs provide more flexibility because you don't have wait until the end of the day to make changes. This may not be very important to a long term investor, but if a major event happens during the day, you are able to make adjustments. I prefer to keep all of my option open. This is crucial for a more tactical investor who wishes to better time his entry & exit points. Most professional money managers rely on ETFs versus mutual funds (unless they are commissioned based).
Many ETFs are lower cost as well, even for the similar mutual fund strategy with the same brand name, but this also varies a great deal and can depend upon which class of mutual fund shares in which you invest. Most funds can have multiple share classes so you must do your homework. Stay away from loaded, commissioned A or B share funds, although they are much less common today.
Another big advantage ETFs have over mutual funds is that they are more tax efficient. This is because you have no control over when a mutual fund pays a distribution of capital gains. It doesn't matter when you bought the fund, it matters when the fund bought and sold the stock/bond within the fund. So you could invest in a mutual fund and actually have a loss at year end based upon the NAV but incur a tax liability if in a taxable account. With an ETF, it is when you buy and sell the ETF and are therefore in control.
At our shop, when we invest using a fund (versus individual securities), we almost always use ETFs exclusively for the reasons mentioned above. The only time I would consider using a mutual fund is if I am investing in the manger of an actively managed fund in a specialized space.
I could dive deep into the minutia and nuances of the differences, but these are the highlights that most investors need to be aware of and research.
Hope this helps and best of luck, Dan Stewart CFA®
Hi! Thanks for writing! The answer provided by Investopedia here is great. I'd like to add a few more thoughts.
ETFs are a type of exchange-traded investment product that offer investors a way to pool their money in a fund. This fund makes investments in stocks, bonds, or other assets and, in return, receive an interest in that investment pool. Unlike mutual funds, however, ETF shares are traded on a national stock exchange. ETFs are not the same thing as mutual funds. Generally, ETFs combine features of a mutual fund, which can be purchased or redeemed at the end of each trading day at its net asset value per share with the intraday trading feature of a closed-end fund, whose shares trade throughout the trading day at market prices. To put the difference between mutual funds and ETFs in perspective, imagine a day like Black Monday, October 19, 1987 when the stock market dropped 22.6%. If you had owned ETFs (which were actually not sold in 1987), you could have sold your ETF shares at any time during the day for their value at the moment, which was higher as the market was falling than it was when the day ended 22% lower. Had you owned a mutual fund and sold during the day, the brokerage would have taken your order when you said sell, but the sell price would have been calculated at the end of the day based on the net asset value, which in a 22% drop, would have been very low. The ability to sell the ETF immediately for its price right then as opposed to getting the end-of-the-day value for the mutual fund could save money in the event of a rare market crash.
Mutual funds are still the cornerstone investment of many retirement plans, but ETFs have been gaining in popularity in the past few years. Which is a better choice for your investment portfolio? If you are a long-term, buy-and-hold investor with little interest in trading, you are probably fine with highly rated, no-load mutual funds held by a reputable fund manager since the ability to trade often and quickly is not a characteristic that is important to you. If you prefer to buy and sell more frequently, ETFs offer greater tradability, lower costs, diversification, and transparency and therefore may work better for your objectives.
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EXCHANGE TRADED FUNDS (ETF)
Exchange Traded Funds (ETFs), offer both active and passive investing elements. Like a mutual fund an ETF is a diversified basket of securities. However, they trade in the form of shares on the major market exchanges in real time like a stock, which makes them more nimble than a mutual fund.Meaning, ETFs are a great vehicle for active traders. Furthermore, ETFs offer more efficient exposure to alternative investments like REITs, options, commodities, and convertible securities.
In addition to passively tracking indices like the S&P 500, ETFs are able to package an investment mix that is specific to a sector style like technology or energy. Another popular type of ETF are smart beta funds. Smart beta is still technically a passive strategy in that the fund holdings are usually derived from an index, however, the difference is the fund manager will make tactical investment decisions to change the weighting of an indices stocks based on volatility and other factors. Therefore, ETFs like smart beta have an active trading aspect that deviates from the passive nature of an index fund.
From a tax standpoint, ETFs are much better than mutual funds and index funds because they don't suffer from the embedded capital gains tax issue previously discussed. This means that individual investors can better control when to realize their capital gains. Unfortunately, with mutual funds, investors are at the mercy of other shareholders and the asset manager.
Another advantage of ETFs is that they are often the lowest-cost way to diversify your investments because they carry the lowest expense ratios. For example, Vanguard's S&P 500 index fund (VFINX) has a net expense ratio of 0.14%, whereas, Vanguard's ETF version (VOO) costs 0.04%. It may sound like splitting hairs, but that's more than triple the cost for the same strategy.
Keep in mind, ETFs can be more expensive than index funds when your custodian charges a trading commission. The commission issue is especially problematic for low dollar amounts invested or high-frequency trading. Also, the more expensive the commission, the more mindful an investor needs to be. For instance, a $1,000 investment purchase with a $10 commission equates to a 1% fee. Now add the advisor's 1% fee and you have to make 2% just to break-even.
A mutual fund, commonly referred to as "active investing," is a diversified basket of securities that are professionally managed using any combination of stocks, bonds, and money market instruments. Units are purchased at Net Asset Value (NAV), which is calculated by taking the total value of all securities in the fund, divided by the total number of shares outstanding.
Investors pool their money together and their share is invested on a prorated basis across the fund's holdings. Each security purchased by the manager will add or detract from the fund's performance. Therefore, all shareholders equally participate in the profits and losses. Additionally, when any one shareholder redeems their shares, it can trigger a taxable event in the form of capital gains, thereby affecting the entire group of shareholders who still remain invested with the fund. This tax inefficiency is one of the major drawbacks of mutual funds, and to a lesser degree, index funds. Taxes are especially costly when a fund does a frequent amount of trading. Fortunately, funds held in IRAs, 401(k)s, and other tax-deferred retirement accounts are not impacted by the capital gains tax issue.
Mutual funds are bought and redeemed through market exchanges like the Nasdaq and NYSE, but the pricing mechanism is clunky because the price (NAV) resets once per day -- after 4:00 PM EST, when the markets are closed. Therefore, an investor might run into a scenario where he/she purchases a fund when the broader markets are down at the beginning of the day but end up buying the fund at a higher price than expected when the market value rises to finish the day. Due to the after-hours re-pricing feature, mutual funds are not a wise strategy for active traders. They are also not great for beginning investors with less than $1,000 because that is the typical minimum entry amount needed.
All mutual funds charge fees, but how those fees are passed down to the investor varies by the share class structure. There are several types of share classes, but the most common are A, B, C, F1, F2, I, R, Y. Beware A-shares often charge a 5.75% commission and carry higher net operating expense ratios than the other share classes mentioned, with the exception of the B and C share classes.
The reason for multiple layers of fees is that the commission is the advisor's compensation for their recommendation, and the net operating expense covers the mutual fund manager's overhead costs. While every fund has operating expenses, not all funds charge commissions. The I-share class and F2-share class do not because a fee-only or fee-based planner will overlay their investment management fee as a percentage of assets being managed, rather than charge a one-time commission. As a point of reference, the industry average for investment advisory oversight is 1%, charged annually.
For more reading on this subject, check out my in-depth analysis here.
Mutual fund are more traditional (old fashioned) with a major disadvantage being how tax liabilities are shared among investors. ETFs are more liquid, transparent, and can have greater diversity with a smaller amount of capital. See a short video on ETF advantages here.
The short explanation:
Both mutual funds and ETF’s hold large diversified baskets of securities. Generally speaking, ETF’s are index-tracking products, similar to index-based mutual funds. They just trade throughout the day like a stock, tend to be lower cost, and potentially more tax efficient than their mutual fund counterparts.
They do have limitations:
Things like trading volume, the reconstitution effect and the drawbacks from an inability to deviate from the index are worth noting. The Anatomy of Exchange Traded Funds takes a deeper dive into how ETF’s really work.