Mutual Funds vs. ETFs: What’s the Difference? (2024)

Mutual Funds vs. ETFs: An Overview

Mutual funds and exchange-traded funds (ETFs) are both created from the concept of pooled fund investing. They often adhere to a passive, indexed strategy that tries to track or replicate representative benchmark indices.

Pooled funds bundle securities together to offer investors the benefit of diversified portfolios. The pooled fund concept primarily offers diversification and it comes with economies of scale, allowing managers to decrease transaction costs through large lot share transactions with pooled investment capital.

Understanding Mutual Funds

MFS Investment Management offered the first U.S. mutual fund in 1924. Mutual funds have been providing investors with an extensive selection of pooled fund offerings since that time. Some mutual funds are passively managed but many investors look to these securities for the added value they can offer in an actively managed strategy.

Active management is the key differentiator for these investors as they rely on a professional manager to build an optimal portfolio rather than just following an index.

Mutual funds come with some added complexities as the leading actively managed investment. Management fees will typically be higher for a mutual fund because managers are tasked with a more difficult job of identifying the best securities to fit the portfolio’s strategy.

Mutual funds have also had long-standing integration into the full-service brokerage transaction process. This full-service offering is the primary reason for the structuring of share classes and it may also add some additional fee considerations.

Mutual funds are created to be offered with multiple share classes. Each share class has its own fee structuring that requires the investor to pay different types of sales loads to a broker. Different share classes also have varying types of operational fees.Many funds also allow for automatic reinvestment of dividends.

The operational fees of a mutual fund are comprehensively expressed to the investor through the expense ratio made up of management fees, operational expenses, and 12b-1 fees. These 12b-1 fees are a fundamental differentiator between mutual funds and ETFs. The mutual fund requires them to support the costs associated with selling the fund through full-service brokerage relationships.

It's also vital for an investor to understand the pricing of mutual funds. These funds are priced based on a net asset value(NAV) which is calculated at the end of the trading day. Standard open-end mutual funds can only be bought and sold at their NAV. An investor placing a trade during the trading day must wait until the final price is calculated to transact their order.

Understanding Exchange Traded Funds

The first ETF was introduced in 1993 to track the S&P 500 index. The number of ETFs grew to more than 3,400 ETFs by the end of 2017.

Regulations primarily required these funds to be passively managed with securities tracking an index. The Securities and Exchange Commission (SEC) streamlined its approval process for ETFs in 2008, allowing for actively managed ETFs for the first time.

ETFs have historically been popular for index investors who seek to gain exposure to a particular market segment with the benefits of having diversification across the sector. A smart beta ETF provides a type of customized index product built around a factor-based index methodology. This customization lets investors choose from index options with selected fundamental characteristics which, in many cases, can substantially outperform.

Fees are also an important consideration for ETF investors. These funds don't carry sales load fees. Investors will pay a commission for trading them if required, but many ETFs trade for free. ETFs also have several differences from the mutual fund option when it comes to operational expenses. ETF expenses are usually lower.

ETFs have lower management fees because many of them are passive funds that don't require stock analysis from the fund manager. Transaction fees are also typically less because less trading is necessary.

The pricing of ETFs also differs from mutual fund pricing. ETFs trade throughout the day on exchanges. This active trading can appeal to many investors who prefer real-time trading and transaction activity in their portfolios. The price of an ETF reflects the real-time pricing of the securities held within the portfolio overall.

Similarities Between Mutual Funds and ETFs

Both types of investments are primarily regulated by the three principal securities laws enacted after the market crash of 1929: the Securities Act of 1933, the Securities and Exchange Act of 1934, and the Investment Company Act of 1940.

Both mutual funds and ETFs can be your go-to options for diversifying your investment portfolio. They work by pooling money from numerous investors and spreading it across different assets such as stocks, bonds, or other securities. This diversification helps reduce the risk associated with individual investments because you're naturally holding a range of assets within your single investment.

Both types of funds offer liquidity. You can buy and sell shares in both but how you do it differs. The Vanguard Total Stock Market Index Fund Admiral Shares (VTSAX) had total fund net assets of $1.5 trillion as of December 2023. It's pretty easy to buy and sell most ETFs.

Differences Between Mutual Funds and ETFs

Mutual funds are like traditional investment clubs. They pool money from investors to buy a mix of stocks, bonds, or other assets and they're priced at the end of the trading day. You can only buy or sell mutual fund shares at that closing price.

ETFs are a bit more modern. They also pool investor money and invest in various assets but they're structured as tradable securities so you can buy and sell ETF shares throughout the trading day at market prices, just as you would with individual stocks.

Mutual funds are like ordering a meal at a restaurant when it comes to pricing. You buy or sell at the price set by the fund after it calculates the NAV at the end of the day. ETF prices are like the stock market. They change in real time based on supply and demand. This can lead to slight differences between the market price and the actual NAV, creating premiums or discounts that investors can capitalize on.

Mutual funds may come with various fees such as sales loads and management expenses. These are often expressed as an expense ratio and they're deducted from the fund's assets. Some mutual funds have higher expense ratios compared to ETFs. ETFs generally have lower expense ratios.

Mutual funds periodically provide a snapshot of their holdings, usually quarterly. But there's a time lag so this information isn't always up to date. ETFs are usually more transparent. They disclose their holdings daily, allowing investors to see exactly what assets the fund holds at any given time. This transparency can be especially valuable for those who want to know by the hour precisely what's in their portfolio.

Special Consideration: Taxes

Taxes on mutual funds and ETFs are like any other investment where the income earned is taxed. Investors must pay either theshort-term or long-term capital gains tax when selling their shares for a profit. Short-term capital gains apply to shares held less than one year before selling. Long-term taxes include the profit from shares sold after holding them for a year or longer.

Short-term capital gains are taxed at the ordinary income tax bracket rate. Long-term capital gains are taxed at 0%, 15%, or 20% depending on the investor's ordinary income tax bracket. Investors in mutual funds and ETFs must also pay taxes on any dividends they receive from the holding. Ordinary dividends are taxed at the ordinary income tax rate. Qualified dividends are taxed at the long-term capital gains rate.

Mutual funds typically have higher tax implications because they pay investors capital gains distributions. These distributions paid out by the fund are taxable. ETFs usually don't pay out capital distributions so they can have a slight tax advantage.

This advantage disappears for investors who hold their assets in a tax-advantaged vehicle like a 401(k). These and other qualified plans take contributions on a tax-deferred basis. Money that's deposited up to certain yearly limits isn't subject to any income tax. The investments in the account can grow tax-free and don't incur taxes when trades are made.

The Bottom Line

Investors have several options to reap the benefits of diversification. Investing in mutual funds or investing in ETFs are two of them. Mutual funds are priced once a day at the net asset value and they're traded after market hours. ETFs are traded throughout the day on stock exchanges just as individual stocks are. ETFs often have lower expense ratios and are generally more tax-efficient due to their more passive nature.