When it comes to investing, mutual funds and exchange-traded funds (ETFs) are two of the most common choices. They both offer a way to invest in a diversified portfolio of stocks, bonds or other securities, but they differ in structure, fees and how they're traded.
Understanding these differences is key to making the right investment decisions based on your financial goals, risk tolerance and investment timeline.
Mutual Funds vs. ETFs: Which Should You Choose?
Choosing between mutual funds and ETFs depends on various factors, including investment strategy, risk tolerance and long-term goals.
| Key Considerations |
Mutual Funds |
ETFs |
| Costs |
Typically higher expense ratios; no trading fees |
Lower expense ratios, but may have trading fees |
| Tax implications |
May distribute capital gains, leading to tax events |
Generally more tax-efficient; fewer distributions |
| Investment horizon |
Suitable for regular contributions over time |
Can be more flexible for lump-sum investing |
| Trading flexibility |
Priced once per day |
Can be bought and sold throughout the trading day |
| Dividend reinvestment |
Often allow automatic reinvestment |
Some ETFs may not offer automatic reinvestment |
What Are Mutual Funds?
Mutual funds pool money from multiple investors to invest in a diversified portfolio of assets. These funds are professionally managed, with portfolio managers making buy and sell decisions based on the fund's objectives.
Investors buy shares in a mutual fund at the fund's net asset value (NAV), which is calculated at the end of each trading day. Unlike stocks or ETFs, mutual funds do not trade throughout the day.
Types
- Equity funds: Invest primarily in stocks, aiming for long-term capital growth.
- Fixed-income funds: Focus on bonds and other debt instruments to provide steady income.
- Index funds: Passively track a specific market index, such as the S&P 500, and typically have lower fees.
- Balanced funds: Combine stocks and bonds to balance risk and return.
Advantages
- Diversification: Investing in multiple assets spreads out risk.
- Professional management: Fund managers actively monitor and adjust portfolios.
- Automatic investment plans: Many funds allow investors to contribute regularly with automatic withdrawals from their bank accounts.
- Economies of scale: Pooled investments reduce transaction costs compared to buying individual stocks or bonds.
Disadvantages
- Management fees: Actively managed funds have higher expense ratios that can eat into returns.
- Potential underperformance: Actively managed funds do not always beat their benchmark indexes.
- Limited control: Investors have no say in which assets the fund buys or sells.
- Lock-in periods: Some funds charge fees for selling shares too soon, limiting flexibility.
What Are Exchange-Traded Funds (ETFs)?
ETFs are investment funds that trade on stock exchanges, similar to individual stocks. They are designed to track the performance of a specific index, sector, commodity or strategy.
Unlike mutual funds, which are priced once daily, ETFs trade throughout the day at market prices. Investors buy and sell them through brokerage accounts, just like stocks.
Types
- Equity ETFs: Invest in a portfolio of stocks, often tracking an index.
- Bond ETFs: Provide exposure to government, corporate or municipal bonds.
- Commodity ETFs: Track the performance of physical commodities like gold or oil.
- Sector or industry ETFs: Focus on specific market segments, such as technology or healthcare.
Advantages
- Flexibility: Can be bought and sold anytime during market hours.
- Lower expense ratios: Typically have lower management fees than mutual funds.
- Tax efficiency: ETFs generally have fewer taxable distributions than mutual funds.
- Transparency: Many ETFs disclose their holdings daily, unlike mutual funds, which report holdings quarterly.
Disadvantages
- Brokerage fees: Trading ETFs may involve commissions or fees, depending on the brokerage.
- Premiums and discounts: ETFs can sometimes trade at prices slightly above or below their NAV.
- Market risk: Prices fluctuate throughout the day, leading to potential short-term volatility.
Mutual Funds Generally Cost More Than ETFs
Mutual funds generally have higher fees than ETFs. That's because ETFs are more likely to be passively managed—they simply track a specific index. As a result, they require less research and expertise to maintain, and thus can charge lower management fees.
Actively managed funds are more likely to have a team of researchers and analysts, not to mention the fund manager, attempting to earn above-average returns. The fund passes on these costs to investors.
To understand the impact of fees, consider this example from the Securities and Exchange Commission that involves a $100,000 portfolio invested over 20 years. At a 4% return, a portfolio subject to a relatively low fee of 0.25% would grow to nearly $210,000 over two decades. A 1% fee would reduce the value of that same portfolio by nearly $30,000.
Every mutual fund and ETF is required to disclose its fees in a prospectus, which is available for you to review before you invest. As you look over the details of the funds you're considering, bear in mind that every fee you pay decreases your earnings.
Final Thoughts
Both mutual funds and ETFs have their merits, and the right choice depends on your financial needs and investment preferences. If you prefer a hands-off, actively managed approach with automatic contributions, mutual funds may be the better option. If you want lower fees, more control and the ability to trade like a stock, ETFs might be the way to go.
As with any investment, understanding the pros and cons of each option is crucial. Before making a decision, consider your long-term financial goals and consult a financial advisor if needed.
For more insights on managing your investments and personal finances, explore additional resources in our Saving & Budgeting section.
