US citizens have over $30 trillion combined invested in mutual and exchange-traded funds (ETFs). This large amount makes these two investment vehicles the cornerstone of many people’s financial planning. Here are the best ETFs vs mutual funds.
ETFs and mutual funds both collect money from people to invest in a mix of external sources like stocks, bonds, or other assets. This helps regular investors own small parts of hundreds or even thousands of different investments, even with a small budget. It also spreads out risk without requiring you to pick each stock or bond on your own.
Though they have similarities, they also have important differences that can impact your returns. ETFs usually cost less in fees and allow more freedom in buying and selling. Mutual fund fees have dropped a lot over the years and are now often close to those of ETFs.
Mutual funds also tend to be more actively managed by professionals and have stricter rules to protect investors. Knowing these main differences can help you select the ideal option based on your financial goals.
ETF vs Mutual Funds: 5 Key Differences
- Continuous ETF trading vs daily mutual fund pricing
- Lower ETF fees (0.16% average) vs higher mutual fund costs (0.66% average)
- ETF tax efficiency vs mutual fund taxable distributions
- No minimum ETF investments vs mutual fund account minimums
- Both accessible to small investors
ETFs vs. Mutual Funds: Which Is Right for Me?
ETFs
Most aim to invest in index funds that copy the movements of well-known indexes like the S&P 500 by holding a stock collection that matches the index. For example, if you own shares of the SPDR S&P 500 ETF (SPY), which follows the S&P 500, and the index goes up for the day, your shares rise in value, too.
One of the main advantages of ETFs is that they usually follow indexes without much active management.
Since they don’t require constant buying and selling by managers, ETFs tend to have lower costs than mutual funds, even those that also track indexes. The price of an ETF is meant to stay close to the value of the stocks it holds. To keep it in line, providers add or remove shares from the market as needed.
Tax benefits:
ETFs are often better for taxes because investors usually owe capital gains tax only when they sell their shares. In contrast, mutual funds can trigger taxable events when fund managers buy or sell stocks, even if investors haven’t sold their shares. To better prepare for such tax situations, it’s helpful to diversify your investment portfolio across different asset types and accounts.
ETF Considerations
- Continuous trading but requires brokerage account access
- Lower 0.16% fees yet potential bid-ask spreads
- Tax efficiency offset by possible premium/discount volatility
Example: $100k ETF: $160 fees vs mutual fund’s $660 + $1,190 taxes
Mutual Funds
Mutual funds are managed by financial companies like Vanguard, T. Rowe Price, and BlackRock. Unlike stocks or ETFs that trade throughout the day, mutual funds are bought and sold only once daily—after the market closes. The amount you pay or receive is entirely based on the mutual fund’s net asset value (NAV), which reflects the total worth of all the investments in the fund at the end of the day.
Many mutual funds have professional managers who actively choose investments, aiming to outperform the market or adjust holdings to fit the needs of those in retirement-focused funds. Because of this hands-on approach, they usually cost more than funds that simply follow an index. If you’re looking to manage your finances effectively, consider reading our article on how to build an emergency fund on a tight budget.
Some funds also come with extra fees, such as penalties for selling too soon—like within three days of buying—so it’s important to read the details before investing. That being said, mutual funds are generally designed for long-term savings, so quick withdrawals aren’t common for most investors.
While the first mutual funds followed indexes, most today are actively managed. This means they have higher costs to cover research, company evaluations, and other expenses. Still, many people with 401(k) plans invest in them because they are built to adjust as retirement approaches.
Target-Date Funds
Target-date funds make investing simple, especially for retirement accounts like 401(k)s. These funds automatically adjust over time, starting with more stocks for growth and gradually shifting toward bonds as retirement gets closer. For example, a “Target Date 2050” fund will be more focused on stocks early on but will lean more toward bonds by the year 2050.
Think of it like a self-driving car that changes speed and direction based on how close you are to your stop. When retirement is far away, the fund takes bigger risks to help money grow. As the years go by, it slows down and becomes more careful to help protect what you’ve saved.
Most of these funds are mutual funds, but there are also exchange-traded versions. Many people pick just one target-date fund that matches when they plan to retire. These are often the default choices in workplace retirement plans for those who don’t select their own investments.
Prominent Differences Between ETFs and Mutual Funds
ETFs and mutual funds are both famous investment sources offering versatile exposure to multiple asset classes. However, they have several different aspects, including trading flexibility, tax efficiency, costs, and management style.
1. ETFs
- Trading: Can be done throughout the day
- Cost and fees: Lower expense ratios, lesser brokerage fees
- Management style: Mainly passive
- Tax efficiency: More tax-efficient
- Minimum investment: Price of one share
2. Mutual Funds
- Trading: End of day (NAV-based)
- Cost and fees: Higher expense ratios, potential load fees
- Management style: Often active
- Tax efficiency: Less tax-efficient
- Minimum investment: Generally higher
Key Differences at a Glance
Trading: ETFs can be purchased and sold on stock exchanges throughout the day, and prices change in real time. In contrast, mutual funds are only traded once a day after the market closes, and the price is set using the fund’s net asset value (NAV).
Costs and Fees: ETFs usually cost less to manage because they follow a set index and have fewer overhead expenses. They also don’t have upfront or exit fees. On the other hand, mutual funds often come with higher costs, especially if they are actively managed. Some mutual funds (around 8%) still charge upfront fees, and investors may have to pay extra if they sell their shares too soon.
Management Style: Most ETFs are designed to follow a specific index, meaning they don’t need frequent adjustments. Mutual funds, however, are often actively managed. Fund managers make smart decisions about buying and selling investments, either to meet a specific target date or to try to outperform market averages.
Taxes: ETFs are usually better at limiting tax costs due to how they handle buying and selling within the fund. This setup helps reduce the capital gains taxes that investors must pay. In contrast, mutual funds tend to pass more tax costs to investors since fund managers regularly buy and sell assets within the fund.
Minimum Investment: You can invest in an ETF with just the cost of one share, making them easier to access. It’s one of the best ways to start investing with little money. Mutual funds, however, often require a minimum amount to get started, though this varies by fund.
The U.S. Securities and Exchange Commission sanctioned the first spot Bitcoin ETFs in 2024, which began trading on the Cboe BZX, NYSE Arca, and Nasdaq exchanges.
This marked a significant milestone in how digital assets like cryptocurrencies are integrated into traditional markets, expanding beyond speculative use to regulated investment options such as Bitcoin ETFs.
Top Similarities Between ETFs and Mutual Funds
Additionally, ETFs and mutual funds share numerous similarities, particularly in their purpose and structure. Both funds are developed to provide diversified, professionally managed investments that resonate with specific investors’ goals. Some similarities include the following:
Key Similarities at a Glance
Diversification: Pooled assets for reduced individual asset risk
Professional Management: Managed by experts who monitor and adjust asset allocation and security selection accordingly
Regulatory Oversight: Are regulated for investor protection
Liquidity: Both allow for relatively easy access to capital
Accessibility: Provide affordable access to diversified portfolios
Variety: Offer exposure to various asset classes and investment strategies.
Let’s discuss them in detail one by one.
- Spread of Investments: Both ETFs and mutual funds combine money from multiple investors to purchase a mix of assets, helping reduce the risk tied to any single investment.
- Expert Management: Professionals handle the buying, selling, and balancing of assets within both types of funds.
- Rules and Oversight: These funds follow legal and financial guidelines, with regulators ensuring they operate within set standards.
- Easy to Buy and Sell: Investors can cash out their holdings without much trouble.
- Affordable Access: Compared to purchasing individual stocks or bonds, ETFs and mutual funds offer a way to invest in a mix of assets without needing large amounts of money.
- Wide Range of Choices: These funds invest in stocks, bonds, commodities, real estate, or a blend of these.
Since index-tracking funds are among the most popular choices, let’s compare ETFs and mutual funds within this category.
When Do Taxes Apply to an ETF?
For a portfolio made up entirely of ETFs, taxes usually come into play only when investors sell their shares. Similar to mutual funds, if an ETF pays dividends, these are considered taxable income.
When Are Mutual Fund Investors Taxed on Their Gains?
Unless investing through a 401(k) or another tax-advantaged account, mutual funds pass taxable gains to investors, even if they simply hold onto their shares.
What Is an Open-End or Closed-End Fund?
Both mutual funds and ETFs are open-ended, meaning the number of shares can increase or decrease based on demand. A closed-end fund, on the other hand, sells a set number of shares once, though it may offer more later.
Final Thoughts
ETFs and mutual funds have long been useful tools for those looking to build a well-balanced portfolio. ETFs often attract investors who prefer lower costs and the flexibility to buy or sell anytime. Their tax benefits also make them appealing to those following a long-term approach.
Mutual funds, particularly target-date funds, provide professional management and may suit retirement savers who like a structured plan. While they tend to have higher costs, they also offer features such as automatic rebalancing. Choosing between the two depends on how involved you want to be in managing your investments and your tax situation.
