Exchange-traded funds (also known as "ETFs") and mutual funds have become increasingly popular among investors seeking flexible and cost-effective ways to diversify their portfolios. What exactly are these though? How do they work, and how do you know which is right for you? This article addresses these questions and more.

What is an ETF?

An ETF is a type of investment fund that holds a collection of assets (e.g., stocks, bonds, commodities, or a combination of these) and is designed to track the performance of a specific index, sector, commodity, or asset class via passive management. For example, an ETF might track a broad market index such as the S&P 500 or perhaps focus on a specific sector (e.g., technology or healthcare).

When you buy shares of an ETF, you're purchasing a portion of the fund’s holdings. For example, if an ETF tracks the S&P 500, buying one share of this gives you exposure to all 500 companies within that index (proportionate to the fund’s allocation): allowing you to diversify your portfolio without the need to buy individual stocks.

What separates ETFs from other types of funds is that they’re traded on stock exchanges throughout the trading day, just like individual stocks. Their price fluctuates throughout the day, therefore, based on supply and demand.

What is a mutual fund?

As with an ETF, a mutual fund is an investment vehicle that pools money from multiple investors to purchase a diversified portfolio of securities. When you invest in a mutual fund, you're buying shares of the fund: representing your proportionate ownership in the entire portfolio. The money collected from investors is used to buy a variety of securities (e.g., stocks, bonds, money market instruments, or a combination of these) according to the fund’s investment objectives.

The value of a mutual fund share, known as the net asset value (NAV), is calculated at the end of each trading day by dividing the total value of fund assets (minus liabilities) by the number of shares outstanding. Investors buy and sell mutual fund shares at the NAV price, but unlike stocks or ETFs, these transactions occur at the end of the trading day.

Mutual funds are actively managed, meaning professional portfolio managers make decisions about which securities to buy, hold, or sell in order to meet the fund’s investment objectives. These managers are supported by a team of analysts and researchers who monitor the financial markets and individual securities.

Similarities between ETFs and mutual funds

ETFs and mutual funds share several common features, many of which have helped fuel their popularity. These include…

Diversification

Both ETFs and mutual funds pool money from multiple investors to create a fund, giving investors exposure to a wide range of assets without the need to buy each individual securities and thus minimizing risk by reducing the impact poor performance has on any single investment.

Liquidity

ETFs and mutual funds also offer liquidity, though in different ways. While the latter allows investors to buy and sell shares at the end of the trading day at the net asset value (NAV), the former are traded throughout the day on stock exchanges at market prices. Despite these differences in trading mechanics, both offer relatively easy access to one's investment.

Regulatory oversight

Both investment vehicles are regulated by the U.S. Securities and Exchange Commission (SEC), ensuring transparency and protection for investors as they're required to disclose their holdings, fees, and performance on a regular basis—giving investors the ability to make informed decisions.

Customization per specific goals/strategies

Lastly, both ETFs and mutual funds come in various types that cater to diverse investment strategies and goals. Whether an investor is seeking exposure to a broad market index, specific sector, or combination of asset classes, ETFs and mutual funds are available to meet those needs.

How do ETFs and mutual funds differ?

While ETFs and mutual funds have similarities, several key differences can impact which option investors choose. These include…

Trading flexibility

One of the most notable differences between ETFs and mutual funds is how they’re traded. ETFs, for example, are bought and sold on stock exchanges throughout the trading day (much like individual stocks) so their prices fluctuate based on supply and demand and investors can employ strategies such as limit orders, stop-loss orders, and margin trading—options not available with mutual funds.

Mutual funds, on the other hand, are only traded once a day after the market closes—with investors buying and selling shares at the net asset value (NAV) determined at the end of the trading day.

Passive vs active management

Most mutual funds are actively managed, meaning a fund manager or team actively selects fund securities to try to outperform the market as part of a more customized offering. While an ETF that tracks the S&P 500 will invest in all 500 companies in the S&P 500, a mutual fund might select ten companies its managers believe will perform best. Active management typically comes with higher fees than passively managed funds, though the difference in returns can more than make up for that difference.

It’s important to understand that while the goal of active management is to outperform the market, there's no guarantee this will actually occur. Unlike with a passively managed fund, however, active management at least holds the promise of outperformance. With passive management, the goal is to simply mirror the performance of the benchmark tracked—meaning you won’t see the higher potential returns associated with active management.

Taxes

When it comes to tax efficiency, ETFs generally have an advantage over mutual funds. Because of how ETF shares are created and redeemed, they tend to generate fewer capital gains distributions (potentially reducing the tax burden for investors). Mutual funds, on the other hand, often distribute capital gains to investors on an annual basis—sometimes triggering taxable events even if the investor hasn’t sold any shares.

Minimum investment

Mutual funds often have minimum investment amounts ranging from a few hundred to several thousand dollars. ETFs—traded like stocks—can be purchased in any quantity (including fractional shares through some brokers), making them accessible to investors with varying budget levels.

Which is a right for you: an ETF or mutual fund?

Choosing between ETFs and mutual funds is often a crucial decision for investors as both offer distinct advantages and cater to different investment needs. The right choice largely depends on your individual financial goals, investment strategy, and personal preferences. Here are a few things to consider in this respect…

Investment style

Investors who prefer a more hands-on approach to investing and appreciate the ability to trade throughout the day might deem ETFs the better option given the flexibility of intraday trading that allows them to react to market movements in real time: beneficial for those seeking to implement short-term trading strategies.

Long-term investors desiring active portfolio management, on the other hand, may find mutual funds more suitable as they're typically managed by professionals who actively select and adjust holdings: appealing for those who prefer not to make daily investment decisions. Mutual funds also offer the advantage of dollar-cost averaging via automatic contributions, making them convenient for building wealth over time without the need to closely monitor markets.

Tax considerations

ETFs are often more tax-efficient than mutual funds due to the unique way they're structured and traded—with the in-kind creation and redemption process helping to minimize capital gains distributions and thus reducing your tax liability. This makes ETFs a potentially better option for investors with taxable accounts who want to minimize taxes.

Mutual funds, meanwhile, often distribute capital gains to shareholders on an annual basis—which can trigger a taxable event even if you haven’t sold any shares. This is perhaps not of concern for those who invest in a tax-advantaged account (e.g., a 401(k) or IRA) but is something to keep in mind if your investments are held in a taxable account.

Costs and fees

ETFs generally have lower expense ratios than mutual funds—due in part to their passive management—and are thus an attractive option for cost-conscious investors. Keep in mind, however, this is not always the case and you should likewise always review specific costs/fees associated with an investment.

In addition to higher expense ratios due to professional management costs, some mutual funds also charge sales loads (commissions) when you buy or sell shares—further driving up the price. Many no-load mutual funds are available, however, and mutual funds are a solid option despite their higher fees if you plan to invest consistently over the long term in the absence of frequent trading.

Access and minimum investments

Another key difference between ETFs and mutual funds is the minimum investment required. While mutual funds often have higher thresholds—sometimes a barrier for new or minor investors—ETFs can be purchased in any quantity (even down to fractional shares through some brokers), making them accessible to a wider range of investors regardless of budget.

The takeaway: ETFs vs mutual funds

If you value low costs, tax efficiency, and trading flexibility, ETFs are an investment worth considering. On the other hand, if you prefer professional management and investment minimums aren't a concern, mutual funds might work better for your needs. There's also no need to exclusively commit to one or the other; you can invest in a combination of both ETFs and mutual funds as well!

Regardless of your preferred route, be sure to carefully evaluate your financial goals, risk tolerance, and investment horizon when determining which option is best suited to help you achieve your objectives. Consulting with a financial advisor can help in this respect, providing personalized guidance to help you make an informed decision.

Have questions about ETFs or mutual funds? Schedule a FREE discovery call with one of our financial advisors to get them answered.

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The content in this post was developed by our team of writers and reviewed by our team of CFP® professionals here at Vision Retirement.

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ETF vs Mutual Fund: Which is the Better Investment Option?