ETFs & mutual funds: Comparing your options

ETFs & mutual funds: Comparing your options

01.08.2024

When you’re ready to start investing, simple is sometimes better.

One way to simplify your investing prospects is to choose pooled investments like mutual funds and exchange-traded funds (ETFs), which give you exposure to hundreds or thousands of assets in a single investment. They help diversify your portfolio while saving you the work of picking individual stocks and bonds.

Before getting started, it’s helpful to understand the difference between ETFs and mutual funds so you can decide which is best for your investment portfolio. Keep reading to learn what ETFs and mutual funds are, how they work, and the key differences between them.

Mutual funds: An in-depth analysis

A mutual fund is a pooled investment, meaning it pools the money from many investors and invests it in a portfolio of securities based upon the fund’s investment objective. As an investor, you gain exposure to all of the fund’s underlying investments — as well as a share of their gains or losses.

Buying and selling process

Mutual funds work differently than other securities: Instead of buying mutual fund shares from other investors on a secondary market, you buy them directly from the fund itself, often through a brokerage firm.

The amount you’ll pay for your fund shares is known as the offering price. The offering price is determined by the fund’s net asset value (NAV), plus sales charges, if any. A fund’s NAV is the total value of its securities divided by the number of outstanding shares. But rather than being determined at the moment you hit the “buy” button, the price of a mutual fund is typically determined once a day after the close of the New York Stock Exchange (NYSE) that day and that’s the price you will pay for the shares.

If you decide to sell your mutual fund shares, the process works largely the same. You can redeem your shares, meaning sell them back to the fund, at any time.  You will receive the share price calculated after the close of the NYSE that day.

Actively vs. passively managed funds

Mutual funds can be either actively or passively managed. An actively managed fund is one that has a fund manager who buys and sells securities regularly with the goal of outperforming a designated benchmark such as the S&P 500.

A passively managed fund, on the other hand, tracks the performance of a particular benchmark — often a stock market index or a portion of the market. It seeks to achieve the same outcome as its underlying benchmark.

Passively managed funds can track a particular index, such as the S&P 500 or the Russell 2000. They can also track a specific market sector, a specific region (U.S. vs. non-U.S., for example), include only socially responsible investments, and more. These passively managed funds are known as index funds.

Minimum investments

Mutual funds often have investment minimums, which is the minimum amount of money you must invest in a fund. Investment minimums vary depending on the fund type and the company. It’s also possible to find mutual funds without investment minimums.

Cost considerations

One of the most important things to consider before buying shares in a mutual fund is the cost. When you buy into a mutual fund, there are three types of costs to consider: sales charges, ongoing expenses, and redemption fees.

 Upfront sales charges are included in the offering price and are assessed when you purchase the shares. On an ongoing basis, you will pay an expense ratio, which typically covers costs to run, service and market the fund. Finally, you may pay a redemption fee or contingent deferred sales charge when you sell, especially if you did not pay a sales charge when purchasing.

It’s important to note that actively managed funds generally have higher expense ratios or management fees than passive funds. After all, because there is more hands-on effort required of the fund managers, these funds are more expensive to run. These higher fees may impact your returns.

Key differences: Open-end vs. closed-end mutual funds

Mutual funds can fall into one of two categories: open-end or closed-end. Most mutual funds are open-end funds, which means investors can buy and sell their shares at any time. The fund company can also create new shares at any time to meet investor demand.

Closed-end funds are less common. Rather than buying and selling shares on an ongoing basis, closed-end funds have a single offering before closing to new investors. The fund doesn’t create or sell new shares on an ongoing basis. Instead, its growth is entirely dependent on the success of its securities.

You can still buy shares in a closed-end fund. But rather than buying them from the fund, you would buy them in the secondary market like you would purchase an individual stock. The price of closed-end funds is based on consumer demand, while the price of open-end funds is based on the NAV. In these ways, a closed-end mutual fund more closely resembles an ETF, as we’ll cover later on.

ETFs: A comprehensive overview

An exchange-traded fund (ETF) is a pooled investment that’s similar to a mutual fund in many ways. ETFs pool the money of many investors and then purchase securities, including stocks, bonds, and more. Investors experience their share of the fund’s gains and participate in any losses.

Buying and selling process

One of the most defining features of an ETF is the buying and selling process. Rather than all sales closing at the end of the day like a mutual funds, ETFs have intraday trading like stocks. You can buy and sell ETFs on the secondary market throughout the day, and the sale price is based on the market price at the time of the transaction. In this way, ETFs are more like stocks than they are like mutual funds.

Actively vs. passively managed funds

Like mutual funds, ETFs can be either actively or passively managed. Some attempt to outperform their benchmark index by actively buying and selling securities, while others track a particular index or portion of the securities market. ETFs are more likely to be passively managed.

Minimum investments

Unlike mutual funds, ETFs don’t have investment minimums. Instead, you buy ETFs by the share as you would with individual stocks. For example, if the ETF you’re considering buying is $10 per share, then you’ll simply need an amount equal to the number of shares you want to purchase.  In some cases, you may be able to purchase fractional shares of an ETF.

Cost considerations

Like mutual funds, ETFs have a couple of different fees you might be subject to. First, ETFs may come with transaction fees, both when you buy and sell. However, it’s becoming increasingly common for brokerage firms not to charge transaction fees on ETFs.

The other type of cost associated with ETFs is their expense ratio, which is an annual fee that contributes to the management of the fund. Because many ETFs are passively managed, they often have lower expense ratios.

Creation and redemption process

A defining characteristic of ETFs is their creation and redemption process. ETF shares are created when authorized participants (APs) — usually large institutional investors — buy all of the securities that will make up an ETF. They provide this basket of securities to the ETF issuer, who, in return, provides creation units of the ETF to the AP.

The redemption component is when an AP accumulates enough ETF shares to equal one creation unit. The AP provides the ETF shares to the ETF issuer. In return, the ETF issuer provides the AP with an equally valuable basket of securities.

As an individual investor, the creation and redemption process happens before you buy your ETF shares. However, the market price of your ETF shares is at least somewhat impacted by the ongoing actions of the APs.

ETF structures

Like mutual funds, ETFs can be structured in several different ways, including open-end funds and unit investment trusts. Open-end funds, as we’ve discussed, are those that buy and sell shares on an ongoing basis. They can create new shares and sell directly to investors. But unlike mutual funds, these open-end ETFs can also be sold on the secondary market.

ETFs can also be structured as unit investment trusts (UITs). UITs make a one-time offering of a certain number of securities, similar to a closed-end fund. However, these redeemable units terminate and dissolve at a predetermined date.

When you’re investing in ETFs, the structure of the investment company itself is less important. After all, most ETF investors are buying them on a secondary market, just as they would individual stocks.

Key differences: ETFs vs. mutual funds

Mutual funds and ETFs have a lot in common. Both pool the money of many investors and use it to buy underlying securities. These pooled investments help create diversified portfolios for their investors. In many ways, ETFs and mutual funds can provide the same benefits to your portfolio. However, there are some important differences to understand.

Investment minimums

As mentioned, mutual funds and ETFs differ in terms of their investment minimums. Mutual funds generally require a set dollar amount (though some have no minimums). An ETF, on the other hand, is sold per share. The minimum investment required for any ETF is the cost of a single share (or fractional share in some cases).

Management approach

Both ETFs and mutual funds can be either actively or passively managed. While mutual funds historically were often actively managed, it’s becoming increasingly common for them to be passively managed. ETFs, on the other hand, have historically been primarily passively managed, though there are some actively managed ETFs.

Trading and liquidity

Mutual funds typically trade once per day at the close of the NYSE. So whether you place your buy order at 9:30 in the morning or 3:30 in the afternoon, the transaction will go through at the end of the day at the next price calculated after the NYSE close.

ETFs, on the other hand, trade throughout the day on stock exchanges, just like individual stocks. As a result, you can have more control over the price at which you buy. And unlike mutual funds, where the price is based on the current NAV, ETF pricing is determined by supply and demand.

Costs and fees

Both mutual funds and ETFs have costs associated with them. Common fees required for mutual funds are one-time fees like sales loads and redemption fees, as well as ongoing costs like expense ratios.

ETFs are subject to some of the same costs as mutual funds. For example, some brokerage firms charge transaction fees to buy and sell ETFs. You are also likely to pay an ongoing expense ratio as long as you hold your ETF shares.

With both mutual funds and ETFs, your annual expense ratio is likely to be higher if you invest in actively managed funds versus passively managed ones.

Automatic investments

An important difference in the way you purchase mutual funds versus ETFs comes down to whether you can make automatic investments. To purchase mutual funds, you can easily set up an automatic investment to purchase a certain dollar amount of a specific mutual fund (or mutual funds) each month. However, you typically can’t make automatic purchases of ETFs. As a result, there’s a bit more effort required on your part as an investor.

Tax efficiency

ETFs tend to be more tax-efficient for a couple of reasons. First, ETFs are more likely than mutual funds to be passively managed. Passively managed funds generate fewer capital gains because they aren’t actively trading. As a result, investors are less likely to  be required to pay capital gains taxes while holding shares.

ETFs are also more tax-efficient because of their structure. The creation and redemption mechanism that ETFs have helps to minimize their capital gains, helping reduce the tax burden for investors.

Market landscape

Historically, mutual funds have been far more popular than ETFs. Even today, there were more than 7,300 mutual funds in the United States in 2022 compared to just over 2,700 ETFs. However, the tide has been turning in the past couple of decades.1

In 2003, there were just 123 ETFs in the United States. The number has increased each year since then. But in 2003, there were actually more mutual funds than there are today. The number of funds fluctuates each year, but it hasn’t been increasing as it has for ETFs. In fact, since 2018, the number has steadily fallen each year.2

Making the right investment choice

When choosing between mutual funds and ETFs, it’s important to consider factors such as your investing goals and habits. The two funds have some key similarities, such as their diversification, their fees, and the fact that they can be purchased as either active or passive funds. However, they also have important differences when it comes to how they’re purchased, their tax efficiency, and more.

You may prefer ETFs if you actively trade investments and want to be able to buy and sell ETFs throughout the day. ETFs may also be right for you if it’s a priority to reduce your tax burden. On the other hand, mutual funds might be best for hands-off investors who want the ability to make automatic investments or those who want an actively managed fund that can outperform its benchmark.

Only you can decide whether mutual funds or ETFs are best for your portfolio. However, you can seek the advice of a financial professional who can take a look at your specific situation and offer personalized advice.

Read more: Can you trust your financial advisor?

FAQs about ETFs & mutual funds

Is it better to invest in ETFs or mutual funds?

It’s not necessarily better to invest in either ETFs or mutual funds. The better choice is the one that best fits your investment style and goals. To choose the best option for you, consider management style, fees, tax efficiency, automatic investments, and more.

Do ETFs pay dividends?

The short answer is that, yes, ETFs can pay dividends. Whether an ETF pays dividends depends on whether the securities the fund holds pay dividends. In fact, some ETFs and mutual funds are specifically built of dividend-paying stocks for regular income.

Are ETFs riskier than mutual funds?

There’s little difference in the level of risk between ETFs and mutual funds. Both types of funds — and any investment, for that matter — have some level of risk. If the market goes down and their underlying investments lose money, ETFs and mutual funds lose money, too. And some individual funds may be higher or lower risk depending on the securities they hold. However, there isn’t necessarily a riskier option between ETFs and mutual funds.

What are the disadvantages of ETFs and mutual funds?

Both ETFs and mutual funds can have the disadvantage of higher fees, especially if they are actively managed. Another major disadvantage of ETFs is you typically can’t set up automatic investments as you would with mutual funds. As for mutual funds, a big disadvantage is that they aren’t as tax-efficient as ETFs are.

The bottom line

Choosing between mutual funds and ETFs for your portfolio doesn’t have to be overwhelming. The good news is either option can provide the same basic benefit to your portfolio: diversification.

Mutual funds or ETFs with exposure to a broad selection of securities can help you feel confident in your choice. However, the smaller differences between the two can impact your investment costs, returns, and buying and selling process.

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1 Statista, “Number of mutual funds in the United States from 1997 to 2022.”

2 Statista, “Number of exchange traded funds (ETFs) in the United States from 2003 to 2022.”

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The Currency editors

Staff contributors

The CurrencyTM, a publication from Empower, covers the latest financial news and views shaping how we live, work, and play. We keep you current on ways to plan, save, and invest for life.

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