5 Min Read | April 1, 2022
Mutual Funds vs ETFs: What You Need to Know
What’s the difference between mutual funds vs ETFs? Despite many similarities, the main difference lies in how they’ve managed, which may affect their payoff for you.
At-A-Glance
Both mutual funds and ETFs are financial tools that can help ordinary investors diversify their investments.
Mutual funds tend to be more “actively managed,” with fund managers attempting to perform better than the general market, and therefore come with higher costs in return for greater profit potential.
ETFs are usually passively managed with lower costs and more modest returns.
When considering investment options, one question people frequently ask is: What’s the difference between a mutual fund and an exchange-traded fund (ETF)?
Overall, these two types of investment options have a lot in common. For example, both mutual funds and ETFs target a well-defined market category like large cap stocks and then make a broad spectrum of investments within that category. This can make it easier for investors to diversify their investment portfolios.
Both types of funds are typically run by professional managers who are experts in the chosen market segment, so investors don’t have to become experts themselves. And many mutual funds and ETFs specialize in niche markets, such as utility stocks or municipal bonds, giving investors additional ways to broaden their investments.
A big difference between mutual funds and ETFs has to do with how they operate: Mutual funds are often actively managed, and their shares can only be bought or sold based on a price set at the end of each trading day. ETFs, on the other hand, are usually passively managed. They are bought and sold like stocks, and their prices may fluctuate throughout the trading day.
Actively Managed Mutual Funds: Higher Costs But Potentially Greater Returns
Mutual funds let you invest in a variety of financial instruments including stocks, bonds, money markets, real estate, and subsegments of each of these. Investors buy shares from – and redeem their shares to – the mutual funds themselves, not to other investors. These funds price their shares each business day after the close of business.
The price of a share is based on the total value of the fund’s assets minus its liabilities and then divided by the number of shares outstanding, which is known as the fund’s NAV or net asset value. This means that when investors place an order to buy or sell mutual fund shares, they won’t know the exact purchase or sale price until the NAV is calculated at the end of the trading day.1
Most mutual funds are actively managed by professional investors who decide which securities to trade in an attempt to beat the market and generate outsized profits for the fund’s shareholders. Because they trade more often and must compensate the fund manager, actively managed mutual funds charged an average fee of about 0.66% of the shareholder’s investment according to a 2020 study, while the average for passively managed ETFs was less than 0.05%.2 Over many years, this can add up to a sizable difference in your returns.
In general, you’ll pay more taxes owning mutual funds than ETFs because fund managers trade more often, which means there are more taxable transactions.
Passively Managed ETFs: Lower Costs, More Modest Returns
Like mutual funds, ETFs provide a way for smaller investors to pool their money and invest in markets more broadly than they could on their own. But unlike mutuals, an ETF trades like a stock. Prices usually fluctuate throughout the trading day, and may be higher or lower than the NAV of a fund’s shares due to investor sentiment.
ETFs are primarily passive investments that seek to replicate the performance of a particular market index, like the Dow Jones Industrial Average or the S&P 500. This means the assets owned by an ETF tend to be traded less often and require less attention from the fund’s manager. Thus, ETFs tend to have lower fees and fewer tax consequences than actively traded funds like most mutual funds.
As mentioned above, the average management fee for many passive ETFs is less than 0.05% of the shareholder’s investment – and some don’t charge any fees at all.
How to Decide Between Investing in a Mutual Fund or an ETF
Both mutual funds and ETFs are easily traded and considered highly liquid, which means they can be converted into cash quickly and easily. And for the most part, both only require a small initial investment (although there are exceptions – especially for mutual funds). However, both mutual funds and ETFs limit the amount of control individual investors have over their investments, since shareholders have no direct say over which securities are included in a fund’s portfolio – it’s all managed by the fund manager.
So, given the similarities and tradeoffs between the two, which type of fund is best for you?
Consider a mutual fund if:
- You want a fund that has the potential to deliver larger gains by outperforming the market.
- You are attracted to a particular fund manager’s investment style or are impressed by their track record.
- You’d like to invest in a less closely followed segment of the market, where an active manager’s knowledge and expertise could help increase your returns.
Consider an ETF if:
- You are willing to settle for more modest returns in exchange for lower taxes and fees.
- You want to know the exact price of your shares at the time of their sale or purchase – and not have to wait for the markets to close and the NAV to be calculated.
- You trade actively yourself and want to take advantage of certain specialized trading strategies like intraday trading, stop orders, limit orders, and short selling – all of which can be done with ETFs, but not with mutual funds.
The Takeaway
Both mutual funds and ETFs can help investors diversify their investment portfolios, and they have many features in common. Actively managed mutual funds charge higher fees and provide less price certainty in exchange for greater potential profits, while passively managed ETFs offer lower fees and greater control, but generally have more modest returns.
1 “Mutual Funds and ETFs,” Securities and Exchange Commission
2 “ETF vs. Mutual Fund,” Charles Schwab
Elliot M. Kass is a journalist who has covered global business and technology from New York, London, and San Francisco for more than 30 years.
All Credit Intel content is written by freelance authors and commissioned and paid for by American Express.
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