Differences Between ETFs and Mutual Funds

If you’re looking to diversify your portfolio, you may want to add mutual funds and exchange-traded funds (ETFs) to the mix. Even though these two types of funds are different in many ways, you may be surprised to find that they have more in common than you first thought.

We delve into the key differences between ETFs and mutual funds and how to choose between these two types of funds, as well as the pros and cons of each.

How Are Mutual Funds and ETFs Alike?

One commonality between mutual funds and ETFs is that they are structurally similar. They both represent a basket of securities. For example, you can choose an ETF or mutual fund that focuses on a sector like technology, real estate or energy to add to your portfolio. Instead of having to analyze and pick specific individual stocks, mutual funds and ETFs require less time to research.

Another similarity between mutual funds and ETFs is that they offer investors diversification. Unlike individual stocks or bonds, both types of funds allow investors to gain exposure to a wide variety of different industries. Diversification is crucial to hedge against market volatility because it provides investors with portfolio padding in case some investments should fail. For example, if a few of the stocks begin to decline in a mutual fund or ETF, other investments within that fund will support them or they will be sold and replaced with companies that have more potential.

How Are Mutual Funds and ETFs Different?

Even though both mutual funds and ETFs are types of funds that hold a basket of securities, there are important differences you should be aware of. Some of the areas of difference include:

• Taxes
• Costs and fees
• Active versus passively managed
• How they are bought and sold

In the next several sections, we delve into the specifics of how mutual funds and ETFs are different so you can decide which one may be more suitable for you.

Tax Differences Between ETFs and Mutual Funds

There are tax differences between ETFs and mutual funds that investors need to be aware of. While they are both taxed on capital gains resulting from market transactions, ETFs are more tax-efficient because they have far fewer transactional activities. In contrast, mutual funds will have a slightly higher tax bill because they generate higher capital gains due to their management activities.

It’s also important to understand how ETF and mutual fund distributions are taxed depending on whether they are short-term or long-term capital gains. Long-term capital gains that occur from investments held for more than 12 months are taxed at a maximum of 20%, depending on the investor’s individual tax bracket. On the other hand, short-term capital gains sold within a 12-month period are taxed at ordinary income tax rates, which is usually higher.

Differences Between ETF and Mutual Fund Costs and Fee Structures

The main differences between ETF and mutual fund costs and fees are loads. Mutual funds may carry loads, which are sales charges. Loads for mutual funds generally range from 1% to 2%. The load goes the broker for their efforts and gives an incentive to suggest a particular fund for your portfolio. There are both no-load and load mutual funds to choose from. Therefore, you have to understand which type of mutual fund you are investing in before you decide what’s best for your portfolio.

Although ETFs don’t have loads or large fees, there are still associated costs and fees investors will have to pay. Because ETFs are traded on an exchange similarly to individual stocks, you will typically be asked to pay a small commission to buy and sell them. If you’re looking to lower costs as much as possible, there are some commission-free ETFs; however, they will generally have higher expense ratios to make up for being more cost-efficient.

Lastly, there are no minimum purchase amounts when it comes to investing in ETFs, which means you can start building your portfolio with just one share. On the other hand, mutual funds often have investment minimums between $1,000 to $5,000.

Fund Management Differences Between ETFs and Mutual Funds

Before choosing between a mutual fund or ETF, you will want to understand how they are managed. While both types of funds can be actively or passively managed by a professional manager, most ETFs are passive investments tied to a specific benchmark, or index. Both mutual funds and ETFs are managed by professionals who will add or remove companies from the fund based on a set of criteria or an index. The difference here is that mutual funds are managed constantly, but ETFs may be on a set schedule where the manager moves securities within the fund quarterly. Fund managers determine what stays in the fund and what gets kicked out, depending on the performance of the holdings during a certain time period.

Purchase Differences Between ETFs and Mutual Funds

When it comes to the differences between ETFs and mutual funds, how they are purchased should be another consideration.

As we’ve mentioned previously, ETFs are bought and sold like individual stocks. Therefore, the share price of ETFs is real-time pricing, just like stocks are priced. Investors trade in full shares and will see the share price fluctuate during the day. However, ETFs allow various order types to be placed, which can give the investor control over the trade price. In comparison, the share price of a mutual fund is determined at the end of the day and will be the same for every investor who purchases that specific mutual fund on that day.

Additionally, many mutual funds require a minimum dollar investment. Before you purchase your first mutual fund, it’s important to understand that you may need a certain amount to get started. For example, you may have to invest at least $3,000 to get into the fund initially.

How to Choose Between ETFs and Mutual Funds

There are many reasons why an investor may choose ETFs or mutual funds. Certain factors that pertain to your investing style and preferences will help you to determine which type of fund is right for you. A few aspects to consider include:

• The type of account you have [401(k), 403(b), IRA, Roth, etc.]
• If you want a fund that is passively or actively managed
• The type of management strategy you prefer
• If trading during the day is important to you
• Tax advantages or other associated benefits
• What gaps you need to fill within your current portfolio
• How much wealth you plan to invest
• Your individual time horizons for goals

In many cases, mutual funds and ETFs can be interchanged and, often, it can be a good idea to have both. At AAII, we believe that investors should focus more on finding the right fund for their allocation needs as opposed to worrying about whether it is a mutual fund or ETF.

What Are the Pros and Cons of ETFs?

Though you need to consider your own individual preferences before choosing between mutual funds and ETFs, the basic advantages of investing in ETFs can include:

• Trading flexibility
• Portfolio diversification
• Risk management
• Lower costs and fees
• Some tax benefits
• Professional portfolio management

The basic disadvantages of investing in ETFs can include:

• Lower dividend yields
• Certain associated costs like operating costs
• Passively managed
• Leveraged ETFs

Whether you decide to invest in ETFs or not will ultimately depend on what holes you have in your portfolio. If you want more diversification (a way to mitigate risk), trading flexibility similar to stocks and some unique tax benefits, then ETFs might be right for you. Before investing in any ETF, make sure to do your own research on its management and associated fees to ensure it’s the right fit.

What Are the Pros and Cons of Mutual Funds?

Whether you choose to invest in both mutual funds and ETFs or just one type of fund, it’s important to understand the pros and cons. Some basic advantages of investing in mutual funds can include:

• Professional portfolio management
• Common for dividend reinvestments
• Risk management
• Fair pricing

Additionally, like all investments, there are some basic associated disadvantages of investing in mutual funds, which can include:

• Higher and sometimes hidden fees compared to ETFs
• Tax inefficiency
• Less liquidity
• Potential for poor trade execution
• High capital gains distributions
• Potential management issues

The choice of whether to invest in mutual funds or not will ultimately be dependent on your individual preferences, goals and needs. Many people invest in both mutual funds and ETFs to mitigate risk and bring even more diversification to their portfolios. Make sure to do your research—especially on the mutual fund’s management and minimum purchase amounts—before investing.

Differences Between ETFs and Mutual Funds: The Bottom Line

There are many similarities and differences between ETFs and mutual funds that should be considered before investing in either type of fund. Always do your own research and make sure you understand how the fund is managed, the associated costs, any minimums and how it is taxed before deciding. A few important takeaways from evaluating the key differences between ETFs and mutual funds include:

• Look at your current portfolio and see what gaps you could fill with a mutual fund or ETF
• Determine your risk tolerance to see what type of fund makes more sense
• Analyze your goals and overall allocation to see if they are aligned with what you decide to add
• Use mutual fund and ETF screening tools to mitigate potential risk and weed out underperforming funds

Whether you’re new to mutual funds and ETFs or have been investing in them for years, it’s important to understand the key differences between these two types of funds. Make sure you have the right tools and resources to make informed, confident decisions about your fund selection and allocation. Learn more about A+ Investor’s robust suite of tools, such as the Funds+ and ETF+ screener, which provide investors with an easy, convenient way to filter through thousands of potential opportunities.

Additional Resources for ETFs and Mutual Funds

Interested in learning more about the differences between ETFs and mutual funds or how to choose the right investment for you? Check out our additional resources below.

• Simple Guidelines for Finding the Funds That Fit Your Needs
• Suggestions for Analyzing Mutual Fund and ETF Performance
• Finding ESG Mutual Funds and ETFs