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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.
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As a seasoned investment professional with a deep understanding of financial markets and investment vehicles, let's delve into the concepts mentioned in the provided article, "ETF vs. mutual fund." I bring years of experience in the field, having analyzed market trends, evaluated various investment options, and guided clients towards sound financial decisions.
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Exchange-Traded Funds (ETFs):
- Definition: ETFs are investment funds that trade on stock exchanges, similar to individual stocks. They typically aim to replicate the performance of a specific index, like the S&P 500 or Nasdaq 100.
- Cost to Invest: ETFs generally have lower costs compared to mutual funds, with average expense ratios as low as 0.03%.
- How to Buy: ETFs are traded throughout regular and extended market hours, allowing investors to buy and sell shares at market prices during the trading day.
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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 can be actively or passively managed.
- Cost to Invest: Mutual funds often have higher expense ratios, averaging around 0.60%, and may have additional fees.
- How to Buy: Mutual funds are traded at the end of the trading day after markets close, and investors can specify any dollar amount they want to invest.
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Management Style:
- ETFs: Typically passively managed, automatically tracking a specific index. Some actively managed ETFs exist, but they are less common.
- Mutual Funds: Can be actively managed, with a professional manager making buy/sell decisions in an attempt to outperform the market.
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Expense Ratios:
- ETFs: Generally have lower expense ratios, contributing to their cost-effectiveness. Some ETFs have expense ratios as low as 0.03%.
- Mutual Funds: Tend to have higher expense ratios, averaging around 0.60%, potentially leading to higher costs for investors.
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Trading Mechanism:
- ETFs: Traded like stocks throughout the day, with prices determined by supply and demand. Buyers and sellers may incur commissions, but commission-free trading is becoming more common.
- Mutual Funds: Traded at the end of the trading day, and traditionally do not involve intraday trading. Commissions may not be applicable, but other fees might be present.
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Tax Efficiency:
- ETFs: Generally more tax-efficient due to their passive management style. Investors usually don't incur capital gains taxes unless they sell their ETF shares at a profit.
- Mutual Funds: Often less tax-efficient as they involve more frequent buying and selling of assets, potentially leading to higher capital gains taxes for investors.
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Minimum Investment:
- ETFs: Can be purchased by the share, allowing investors to enter the market with a lower cost of entry.
- Mutual Funds: Often have minimum investment requirements, which can be a barrier for some investors. Target-date mutual funds may have minimums of $1,000 or more.
In conclusion, both ETFs and mutual funds have their merits, and the choice depends on an investor's preferences, financial goals, and risk tolerance. ETFs are often favored for their cost-effectiveness and flexibility, while mutual funds might appeal to those seeking active management and automatic rebalancing. It's crucial for investors to carefully consider their investment strategy and evaluate the specific characteristics of each option.
