Mutual funds and exchange-traded funds (ETFs) offer certain advantages to investors when compared to investing in individual securities, such as stocks or bonds. However, these two categories of professionally managed funds differ in important ways that should be taken into consideration before settling on an investment.

Mutual funds and ETFs are both registered investment companies that professionally manage “baskets” of individual securities such as stocks or bonds, giving investors a wide variety of investment options and diversification. Mutual funds and ETFs are driven by their objectives and strategies, and investors can select funds that invest in a broad spectrum of markets or a narrow segment.

For simplicity’s sake, we make broad generalizations about mutual funds and ETFs as a whole here. Keep in mind that any individual fund may have characteristics that do not fit these common traits.

How Are They Managed?

ETFs are predominantly passively managed, while most mutual funds are actively managed. This difference in investment management style trickles down to many of the core differences between ETFs and mutual funds.

Passive (“index”) funds try to match the performance of a specific market benchmark, meaning they hold the same securities in the same proportions as the benchmark index. The S&P 500 index and the Nasdaq-100 index are examples of benchmarks that the most popular ETFs in the U.S. imitate. According to Morningstar’s fund data, 78% of the current universe of ETFs are designated as passive index funds.

Actively managed funds try to outperform their benchmarks. Their strategies employ the fund manager’s access to deep research and institutional knowledge to carefully select investments. The perceived advantage is that a fund manager’s choice of individual investments should generate a higher return for shareholders, which would justify the higher expenses and higher risk of an active fund compared to a passive fund. Only 4% of mutual funds are noted as index funds in the Morningstar data set.

How Are They Traded?

ETFs are bought and sold on exchanges and trade just like shares of stock do. The price of an exchange-traded fund fluctuates throughout the day based on supply and demand. Because of their tradeable nature, the price paid per share for an ETF may not match the underlying valuation of its assets, or net asset value (NAV). NAV is the assets of a fund minus its liabilities. The NAV is calculated once per day after the market close for mutual funds but is updated during the trading day for ETFs.

In contrast, mutual funds orders are executed after the financial markets have closed and the updated NAV has been calculated. All investors receive the same price for the shares purchased or sold (redeemed). Mutual funds are more formally referred to as “open-ended” funds. Open-ended funds don’t have a limit on the number of shares issued by the fund manager. They continuously offer new shares to incoming investors and redeem shares from existing investors.

An ETF’s price return can deviate from its NAV return for several reasons. Within a given day, investors can sour on a particular stock, sector, commodity, investment strategy or even the ETF’s parent company itself. Investor sentiment in reaction to news related to a particular stock or set of stocks can have bullish and bearish implications on an ETF’s price, even though the underlying NAV hasn’t changed yet. Lower levels of trading volume for an ETF and/or less frequently traded underlying assets can also lead to differences between the market price of an exchange-traded fund and its NAV.

ETFs do not require a minimum initial investment because they are traded like stocks and generally purchased as whole shares. (A limited number of brokerage funds allow fractional share purchases of ETFs.)

Many mutual funds require a minimum initial purchase amount. This can create a barrier to ownership for investors with small amounts of savings to invest. Minimum initial purchases are flat dollar amounts, not based on a fund’s share price. Most of Vanguard’s mutual funds have a $3,000 minimum. Depending on the mutual fund company, the type of account that a mutual fund is purchased through [e.g., a 401(k) account] and whether regular automatic purchases are set up, these minimums can be waived.

What Are Their Costs?

When choosing between individual funds for investment, a general rule for both mutual funds and ETFs is to favor those with lower expense ratios. The expense ratio is a fund’s annual expenses expressed as a percentage of its NAV. Consisting of the management advisory fee and basic operating expenses, the expense ratio is the cost of owning a fund.

Most ETFs have low expense ratios because of their passive management. Technology like robo-advisers continues to make passive investing easier and cheaper as well. The rise of no-commission trading has also lowered the purchase and sale costs of ETFs.

Actively managed mutual funds have to charge enough to pay for the work that fund managers put into their selective investment strategies. Some mutual funds can also have higher marketing, distribution and accounting expenses than ETFs. These fees may be passed along to shareholders in an annual charge called a 12b-1 fee.

Some mutual funds carry loads, too, which are sales fees charged to investors when they buy into a mutual fund or when they redeem fund shares. Loads are paid to brokers, agents or investment advisers who act as intermediaries between the individual and the fund’s management company. In theory, loads are compensation for the intermediary’s time and expertise in distributing and recommending shares of a fund to investors. Loads may be charged to discourage short-term trading of fund shares. Loads are not reflected in a fund’s expense ratio. If you are doing your own research and selecting your funds, there is no reason to pay a sales load.

All of these costs compound over time, highlighting the long-term cost efficiency of ETFs and passively managed mutual funds. Keep in mind that there are both low-cost mutual funds and high-cost ETFs.

What Are Their Tax Implications?

Tying back to their passive management, ETFs tend to be more tax-efficient than mutual funds. The investment strategy that a fund follows will have an impact on its tax efficiency depending on its portfolio turnover—i.e., how often portfolio assets are bought and sold. Funds that employ passive strategies are far more tax-efficient than actively managed mutual funds because they have lower turnover.

Mutual funds, in aggregate, tend to be less tax-efficient for two reasons. The first is the widespread use of active management. Fund managers ultimately decide if and when they will pare down some of the portfolio’s holdings for a gain. More active trading can lead to more capital gains.

The second is embedded capital gains. These are unrealized gains on stocks currently held by the fund on the date the investor buys shares in a fund. If an investor buys shares of a fund in October and the fund manager decides to sell a long-term holding in November, the investor may have to pay capital gains taxes even though they did not benefit from the investment’s appreciation and they did not sell any shares of the fund.

Worse yet, capital gains distributions can occur even during years when the fund has declined in value. This would occur if the fund manager sold portfolio holdings at a profit but did not have enough realized losses to offset the gains. In this case, the excess gains are passed on to investors.

ETFs frequently get around this problem by conducting in-kind transactions. In simple terms, ETF managers exchange securities with trading firms on a secondary market to avoid outright selling. This practice limits the amount of capital gains realized for tax purposes. Not all ETFs are tax-efficient, however.

The tax-cost ratio measures how much a fund’s annualized return is reduced by the taxes paid on distributions, assuming the maximum marginal tax rate. A tax-cost ratio of 0.0% indicates that the fund did not pay any taxable income or make capital gains distributions. If a fund had a 3.0% tax-cost ratio, it means that on average each year, investors lost 3.0% of their assets to taxes. The lower the ratio, the more tax-efficient the fund.

This is not to say that you should automatically buy a fund because its tax-cost ratio is low or zero or it has lower turnover. Many good funds pay out capital gains distributions, so you shouldn’t necessarily avoid a fund just because it has a tax-cost ratio greater than 0%. However, you may wish to hold mutual funds with high tax-cost ratios in tax-preferred accounts, such as 401(k)s and IRAs.

Conclusion

Whether you lean toward ETFs or mutual funds to invest in, the decision ultimately depends on your goals and investor profile. Both mutual funds and ETFs typically provide more diversification than individual stocks and bonds. Combining funds from multiple asset categories can make creating and maintaining a diversified portfolio easy. Remember that fund performance should always be compared within fund categories and against peers. 

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