ETFs and mutual funds pool money to create a big fund invested in a mix of different assets. But there are differences.
Exchange-traded funds, ETFs, have become incredibly popular over the last two decades. In 2017 alone ETFs saw cash inflows of $464 billion in 2017, blowing up the prior record of $288 billion in 2016, according to State Street Global Advisors. Meanwhile, mutual funds pulled in $91 billion through November 2017. Both types of funds allow you to invest in a basket of stocks — so what’s the difference between the two and why have ETFs become the rising star?
ETFs vs mutual funds
ETFs and mutual funds are collections of stocks bundled together in a fund, often based on a theme or an index of stocks. These funds allow investors to gain immediate exposure to one asset class and can provide the benefits of diversification (i.e., lower risk) quickly and easily.
ETFs can offer the same exposure to asset classes and usually do so at a cheaper price, in terms of expense ratios and taxes.
In these basic respects, mutual funds and ETFs are the same. But exactly how the funds are structured constitutes many of the key differences — and why ETFs have become so popular.
ETFs tend to be passive, while mutual funds are often active
ETFs are usually based on an index of securities, with the fund merely mimicking the index’s composition and any subsequent changes to the index. This approach makes them passive investment vehicles, the most typical type of ETF. While mutual funds can be passive, they’re usually actively managed, with a highly paid investment manager doing fundamental analysis and trying to pick stocks that are going to perform well.
ETFs usually have lower expense ratios
ETFs tend to have lower expense ratios than mutual funds, because they are passive investors and are not paying a high-priced manager to pick stocks. According to the Investment Company Institute, in 2017 the average stock index ETF had an expense ratio of 0.21%, meaning an investor paid $21 annually for every $10,000 invested. In contrast, the average stock mutual fund charged 0.59% in 2017. Expenses for both types of funds have been coming down as the industry becomes more competitive, and some funds have expense ratios approaching 0%.
It can be worth paying for an actively managed mutual fund, if the manager consistently performs better than cheaper options. But most managers don’t. Plus, it’s becoming harder to justify higher expenses, more typical for mutual funds, since some brokerages offer mutual funds with 0% expense ratios and many ETFs with near-zero expenses. That’s why passive index funds based on the Standard & Poor’s 500 index are one of the best choices for investors.
ETFs trade throughout the day, while mutual funds only trade after the market closes
This difference is important for investors who want to take advantage of a market that’s moving. ETFs trade on the exchange like stocks, meaning you can buy and sell them throughout the trading day and their price fluctuates depending on what investors estimate they’re worth. Mutual funds, on the other hand, can be bought or sold only at the end of the day. Their price is based on the net value of the stocks held in the fund, and they trade only at that price.
It’s clearer what ETFs own
Because ETFs are passive funds based on an index, investors know what is in the fund. When the index changes, the fund changes. ETFs usually disclose their positions daily anyway, while mutual funds reveal their holdings quarterly and you might not know what your fund manager is buying and selling until it’s disclosed.
ETFs usually have no minimum initial investment
ETFs usually have no minimum initial investment (except the price of one ETF share), and investors could literally buy just a share at a time, though that would be inefficient because of trading commissions. Mutual funds, however, often have a minimum initial investment, and it’s not unusual for that to be relatively high, for example, $2,500. However, ongoing purchases can be made with lower amounts, $100, for instance.
It’s often free to trade mutual funds (with the right brokerage)
Despite other disadvantages, mutual funds can often be bought and sold without paying a trading commission, if you’re using a brokerage that offers this perk. That’s a big positive because it’s not unusual for trading commissions to cost $15-$25, quite pricey compared to the $5-$7 (or sometimes less) it costs to trade an ETF. This is a clear advantage for mutual funds.
Mutual funds often still charge a load
While you might not pay a trading commission for a mutual fund, you might still have to pay the fund’s load, a fee when you transact. It can be quite expensive, sometimes 1%-2% of the total amount you’re investing. While many funds have eliminated the load and that’s the long-term trend, they do persist. However, the fee can (and should) be avoided by choosing a “no load” fund. ETFs don’t charge a load, giving them a substantial advantage over mutual funds that do.
ETFs have tax advantages over mutual funds
ETFs only incur capital-gains taxes when they’re sold, unlike mutual funds which pass those gains and the tax liabilities on to investors while they own the fund. So investors in mutual funds will be socked with capital-gains taxes even if they haven’t sold. Of course, if your fund pays a dividend, you’ll be on the hook for dividend taxes, whether it’s an ETF or mutual fund.
This difference in tax treatment is due to how the funds are constructed. If at the end of the trading day, more investors want to sell the fund than buy, the fund’s manager must sell some of the securities in the fund, potentially creating a tax liability. But with ETFs, the fund is traded from investor to investor during the trading day, so demand matches supply and none of the fund’s assets must be sold simply because the ETF is sold.
ETFs vs mutual funds — which is better?
While these two types of funds achieve many of the same objectives, ETFs are better on the whole than mutual funds. ETFs can offer the same exposure to asset classes and usually do so at a cheaper price, in terms of expense ratios and taxes. Plus, they offer trading flexibility and their passive investing approach tends to perform better than an active approach. So it’s little wonder that ETFs have become so popular in the last two decades.