ETFs vs. Mutual Funds: Which Is Best for You?

For many decades, mutual funds were considered the most effective way to build a diversified investment portfolio. This is because they allow users to rely on the services of industry professionals already overseeing a huge amount of assets on behalf of less experienced or busy investors.

However, the launch of exchange-traded funds (ETF) in 1993 in the United States revolutionized the entire asset management industry. These vehicles proposed a cheaper and perhaps more efficient way of allocating capital through a fund as investors could more easily enter and exit their positions.

In this article, we discuss the similarities and differences between mutual funds and exchange-traded funds (ETF) to help investors choose which of the two vehicles is perhaps the best fit for their portfolio.

ETFs vs. Mutual Funds | Which One Is Best For You?👈🤑

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What Is an ETF?

An exchange-traded fund (ETF) gives the holder ownership over a fraction of a diversified portfolio built by the financial services company that runs the fund.

Shares of these funds can be easily exchanged as if they were a regular stock via one of the main exchanges in the United States — NYSE, NASDAQ, etc. Their value fluctuates primarily based on the underlying value of the stocks held by the fund.

Most ETFs hold a diversified basket of securities. The type of assets they invest in depends on their strategy, scope, and reach. 

These ETFs can focus on a certain asset class (stock, bonds, cryptocurrencies), a geographic area (US or foreign stocks), a specific sector (industrials or healthcare), or a particular investment strategy (dividend, growth, or value). 

Investors pay an annual management fee that is typically expressed as a percentage of the ETF’s quoted price. This fee is used to compensate fund managers for their services and to cover the fund’s operating expenditures.

Additionally, investors have to pay all transaction fees involved when trading ETFs. That said, most brokerage firms nowadays offer commission-free trading for US-listed ETFs.

Finally, depending on the fund’s strategy, an ETF can be either actively or passively managed. Actively managed funds typically display a higher turnover rate, meaning that the manager buys and sells assets more frequently to take advantage of market conditions. 

Meanwhile, passively managed funds track a certain index and their holdings will usually receive a weight that is the same as that assigned by the index.

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What Is a Mutual Fund?

A mutual fund is a financial vehicle that gathers money from investors to build an investment portfolio that follows a certain strategy or methodology. Mutual funds were considered for many years the easiest way to invest in the stock market as investors would rely on industry professionals to do the heavy lifting.

Some mutual funds issue shares whenever a new investor comes on board (open-ended) while others issue a fixed number of shares (closed-ended). Therefore, these funds typically require a minimum investment and charge load fees to cover the cost of each transaction. This load fee also aims to discourage investors from trading shares frequently.

The value of a mutual fund is determined by the combined value of its holdings. That said, for closed-ended funds, the price of every share could vary based on supply and demand dynamics.

These funds are typically offered and managed by financial services companies and they can either be actively or passively managed while their scope, reach, and strategies vary in the same way as ETFs.

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Main Differences Between ETFs and Mutual Funds

Now that we have provided a broad definition of what these vehicles are and how they work, we will highlight the most important differences between them to understand why the two still coexist.

Strategy

Even though much has changed in the financial industry in the past couple of decades, mutual funds are typically considered actively-managed funds. This means that fund managers have more influence on which assets are incorporated into the portfolio instead of just tracking a certain index. 

Nowadays, whether a mutual fund is passively or actively managed depends largely on its strategy. Index-tracking funds will typically be passively-managed vehicles while more complex strategies such as growth, dividend, and value will give the manager more freedom to incorporate or exclude certain assets from the portfolio. In this regard, the fund’s performance will be measured against a benchmark but will not necessarily be expected to perform equally or even similarly.

Meanwhile, exchange-traded funds (ETF) are mostly passively managed vehicles. Although, there are exceptions to the case. The reason for this is that lower portfolio turnover rates tend to keep expenditures at bay and that allows these funds to charge lower annual management fees — a key feature that has made ETFs significantly more attractive than mutual funds.

Trading

Since exchange-traded funds (ETF) are structured and listed as if they were a regular stock, they can be traded at any point during the trading session (intraday). 

Meanwhile, mutual funds are typically traded once the session ends at the closing price as these funds typically report their daily net asset value (NAV) once the session ends.

Management & Fees

There are two fees to consider when investing in ETFs and mutual funds. Transaction fees, which encompass all non-management fees involved when purchasing the instrument, and management fees, which are those paid to the company that operates the fund. This last one is typically expressed as a percentage.

For ETFs, non-management fees are typically the commission or fixed fee charged by a broker to buy and sell the instrument. Meanwhile, mutual funds tend to charge load and redemption fees.

Taxation

Because of the way exchange-traded funds (ETF) are structured, they have lower asset turnover rate and other factors, helping minimize capital gains taxes. 

Moreover, since ETFs are traded as if they were a stock, they are less sensitive to fluctuations in their inflows and outflows as most transactions can be settled between third parties instead of the fund having to issue new shares or redeem existing ones constantly.

As a result, managers will not necessarily be forced to liquidate the fund’s holdings to fulfill redemptions.

Mutual funds, on the other hand, operate differently as share purchases and sales are typically handled by the fund itself. Therefore, when an investor liquidates a sizable position, the fund will typically be forced to sell some holdings to meet the redemption and that will cause a potentially disadvantageous capital gain.

Moreover, since mutual funds are mostly actively managed, their asset turnover rate is commonly higher and even though the fund may adopt tax-harvesting strategies, its tax bill might end up being higher compared to that of an ETF under similar circumstances. 

Transparency

Due to their respective regulatory frameworks, ETFs are typically obligated or opt to disclose their individual holdings daily. Mutual funds, on the other hand, typically disclose their holdings on a quarterly basis.

Investment Minimums

The minimum amount required to invest in an exchange-traded fund (ETF) is the price of one share. That said, most brokerage firms nowadays offer access to fractional shares for US-listed ETFs and that reduces the minimum investment required to incorporate these instruments into a portfolio to as little as $1.

Meanwhile, most mutual funds require a minimum investment starting at $1,000 and they impose a lock-up period of up to 90 days. During this period, investors cannot redeem their shares unless they are willing to pay a penalty for doing so. 

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Why Do We Like ETFs?

• Expense ratios are low
• Asset turnover rates are low
• The minimum amount required to invest in an ETF is its price or lower, if investors are allowed to buy fractional shares.
• They can be a great alternative to build a diversified portfolio regardless of its size.
• ETFs structures are considered more tax-efficient than mutual funds.

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Why Do We Like Mutual Funds?

• Actively managed funds can outperform passively managed vehicles under challenging market conditions.
• Large brokers may offer a great selection of no-load and inexpensive index funds.
• Automated investments can typically be set up and this is a great feature for building retirement funds on auto-pilot mode.

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Use ETFs If

For investors who are seeking to build a diversified portfolio without putting too much thought into which individual stocks should comprise it, exchange-traded funds (ETF) are perhaps the best alternative as these instruments can provide exposure to multiple asset classes, industries, geographies, and strategies.

Nowadays, most brokerage firms charge no commissions or fees for trading US-listed ETFs and that reduces transaction costs for even the smallest portfolios. Moreover, the introduction of fractional shares for ETFs has allowed retail investors with a small account balance to build highly diversified investment portfolios with as little as $50 or $100.

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Use Mutual Funds If

Mutual funds have lost most of their decades-long popularity after ETFs started to showcase their many appeals. However, they might still be a good pick in some specific circumstances.

For example, investors who are expecting that market conditions will deteriorate in the future could opt to pour some of their capital into funds managed by seasoned professionals who know how to navigate those troubled waters.

Moreover, some 401(k)s may only offer access to mutual funds for getting exposure to certain asset classes, geographies, and strategies.

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FAQs About ETFs vs. Mutual Funds

The following are some of the most frequently asked questions we get on the topic of ETFs vs. mutual funds.

Do Mutual Funds and ETFs Pay Distributions?

Yes, both exchange-traded funds and mutual funds pay dividends to investors based on the distributions they receive from their individual holdings. The timing of these distributions may vary from one fund to the other but, as a general rule, ETFs distribute dividends every quarter while mutual funds may opt to distribute these proceeds every month.

Which One Is Safer: ETFs or Mutual Funds?

Both ETFs and mutual funds are considered safe investment vehicles as they have to pass strict listing criteria enforced by the US Securities and Exchange Commission (SEC). That said, some types of ETFs include leveraged and inverse funds that can be highly risky and may not be suitable for beginner investors who do not understand the intricacies and inner workings of these vehicles.

Do ETFs Outperform Mutual Funds?

The performance of both ETFs and mutual funds over time will largely depend on the strategies they follow, the management fees paid for investing in the fund, and certain tax-related considerations. 

Passively-managed vehicles — both ETFs and mutual funds — will typically perform similarly. However, the performance of actively-managed vehicles may vary even if they are following the same strategy or investing in similar asset classes, geographies, or economic sectors.

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Final Thoughts

Exchange-traded funds (ETF) have revolutionized the asset management industry by offering lower management fees, a more tax-efficient structure, and access to multiple asset classes, strategies, and approaches. 

However, mutual funds remain a large and rather important corner of this industry and they still bear some advantages over their passively managed peers that investors should consider under certain specific conditions.