In the world of investing, ETFs and mutual funds are two popular options that offer investors access to diversified portfolios of securities. While both aim to help investors achieve their financial goals, they differ in structure, trading characteristics, tax efficiency and fees.
Learn the key similarities and differences between ETFs and mutual funds and determine which fund type is the best fit for your portfolio.
The Differences Between ETFs and Mutual Funds
Exchange-traded funds (ETFs) and mutual funds are both pooled investment vehicles, but they have several key differences, including how they trade and their expense ratios. Here are some of the main differences between ETFs and mutual funds:
Trading
- ETFs are traded on stock exchanges like individual stocks, which means investors buy and sell ETF shares throughout the trading day at market prices.
- Mutual funds are bought or sold through the fund company at the end of the trading day at the net asset value (NAV) price.
Management Style
- ETFs are often passively managed (tracking an index or commodity), but they may also be actively managed (professional portfolio management).
- Mutual funds are known for active strategies, but some are passively managed.
Minimum Investment
- ETF investors can buy as few shares as they want, and the minimum investment is typically the cost of one share.
- Mutual funds often have minimum investment requirements, which can vary depending on the fund.
Fees
- ETFs generally have lower expense ratios than many mutual funds, but depending on the brokerage, investors may also incur trading commissions when buying and selling ETF shares.
- Mutual fund expenses are typically higher compared to ETFs, and some funds may charge front-end or back-end loads (sales commissions).
NAV Calculation
- ETFs may trade at a premium or discount to their net asset value (NAV) due to supply and demand dynamics in the market.
- Mutual funds transact at the NAV price at the end of the trading day.
Tax Efficiency
- ETFs are typically more tax-efficient than mutual funds due to the "in-kind" creation and redemption process, which can minimize capital gains distributions.
- Mutual funds may distribute capital gains to investors when the fund manager sells securities within the fund.
How are ETFs and Mutual Funds Similar?
ETFs and mutual funds share several similarities, such as diversification and professional management, as they are both investment vehicles designed to pool money from multiple investors for the purpose of investing in a diversified portfolio of securities. Here are some key similarities between ETFs and mutual funds:
Diversification
Both ETFs and mutual funds offer investors the opportunity to achieve diversification by pooling their money with other investors. The funds invest in a variety of securities, spreading risk across different assets.
Professional Management
Both types of funds are typically managed by investment professionals who make decisions about buying and selling securities within the fund's portfolio. This management aims to achieve the fund's investment objectives.
Active and Passive Strategies
Both ETFs and mutual funds may employ active or passive management to achieve their respective investment objectives. While most ETFs seek to passively track a benchmark index or underlying asset, some ETFs may be actively managed. Conversely, mutual funds may track a benchmark index, but they are more known for their active strategies.
Risk and Return Profiles
ETFs and mutual funds can be designed to target specific risk and return profiles. Investors can choose funds based on factors such as investment style, asset class, or geographic focus to align with their investment goals.
ETFs vs. Mutual Funds: Which is Right for You?
When deciding between ETFs and mutual funds, investors should consider several factors, including investment objective, costs, trading flexibility and tax efficiency, to determine which option best aligns with their investment goals, preferences and financial circ*mstances. Here are some key considerations:
Investment Objectives and Strategies
Investors should assess their investment objectives, such as income generation, capital appreciation, or diversification. ETFs offer a wider range of specific sectors, themes and niche strategies while mutual funds offer a range of actively managed choices in addition to index funds.
Costs and Fees
Expense ratios and fees can significantly impact investment returns over time. ETFs typically have lower expense ratios than actively managed mutual funds, but depending on the brokerage, investors may incur trading commissions when buying and selling ETF shares. Mutual funds may charge sales loads or redemption fees.
Trading Flexibility
ETFs trade on stock exchanges throughout the trading day, allowing investors to buy and sell shares at market prices. Mutual funds are priced at the end of the trading day based on the net asset value (NAV) and transacted directly with the fund company. Investors with a preference for intraday trading and liquidity may prefer ETFs, while those seeking simplicity and long-term investing may opt for mutual funds.
Tax Efficiency
ETFs are generally more tax-efficient than mutual funds due to their unique structure and creation/redemption process, which can minimize capital gains distributions. Investors in taxable accounts should consider the tax implications of each option, including potential capital gains taxes and distributions.
Popular ETF and Mutual Fund Providers
Investors can buy ETFs and certain mutual funds through a discount broker or online broker, but some mutual funds are bought directly from a mutual fund company.
Here are the largest ETF and mutual fund providers:
Largest ETF Providers
Largest Mutual Fund Providers
- Vanguard
- BlackRock
- Fidelity Investments
- Capital Group
- State Street Global Advisors
Can You Have Both ETFs and Mutual Funds in a Portfolio?
Yes, investors can have both ETFs and mutual funds in their investment portfolio. In fact, many investors choose to include a combination of both types of funds to diversify their holdings, gain exposure to different asset classes, and implement various investment strategies. Here are a few reasons why investors may consider including both ETFs and mutual funds in their portfolio:
Diversification
By investing in both ETFs and mutual funds, investors can achieve greater diversification across asset classes, sectors, and investment strategies. Each type of fund may provide access to different market segments or investment themes, allowing investors to spread risk more effectively.
Flexibility
ETFs and mutual funds offer different features and trading characteristics. ETFs provide intraday trading and may be more tax-efficient, while mutual funds offer simplicity and convenience for regular investments. Having a mix of both types of funds allows investors to leverage the strengths of each based on their investment preferences and liquidity needs.
Access to Specific Strategies
Some investment strategies or asset classes may be more readily available through either ETFs or mutual funds. By including both types of funds in their portfolio, investors can access a broader range of investment opportunities and implement diverse investment strategies to meet their financial goals.
Tax Planning
ETFs and mutual funds may have different tax implications for investors, depending on factors such as fund structure, turnover, and capital gains distributions. For example, because of their tax efficiency, investors may prefer to hold ETFs in a taxable account while holding mutual funds in a tax-deferred account like an IRA.
Are ETFs or Mutual Funds Riskier?
Determining whether ETFs or mutual funds are riskier depends on various factors, such as liquidity, management, redemptions and expenses. Both fund types are subject to market risk, which is the risk of loss due to fluctuations in the overall market. Here are the key risk factors for investors to consider when comparing ETFs and mutual funds:
Liquidity Risk
ETF liquidity can be influenced by trading volume and market demand. Less liquid ETFs may experience wider bid-ask spreads and price fluctuations, potentially affecting the ability to buy or sell shares at desired prices, especially during volatile market conditions.
Managerial Risk
Actively managed mutual funds are subject to managerial risks, as the fund's performance depends on the skill and decisions of the portfolio manager. Managerial changes, investment style drift, or poor investment decisions can affect fund returns.
Redemption Risk
Mutual funds may face redemption risk, particularly in times of market stress or heightened investor withdrawals. If a mutual fund experiences significant outflows, the fund manager may need to sell securities to meet redemption requests, potentially realizing losses or disrupting portfolio management.
Expense Ratio Impact
Mutual funds typically have higher expense ratios than ETFs, which can impact returns over time. Higher expenses may erode investment returns, especially in periods of underperformance or when compared to lower-cost alternatives.
Do ETFs or Mutual Funds Pay Dividends?
Both ETFs and mutual funds have the potential to pay dividends to investors, depending on the types of securities held within their portfolios. The payment of dividends by ETFs and mutual funds is primarily determined by the dividend-paying stocks, bonds, or other income-generating assets held within the funds' portfolios.
Both types of funds may hold dividend-paying stocks within their portfolios. When these stocks pay dividends to shareholders, the dividends are collected by the ETF or mutual fund and distributed to ETF shareholders.
Investors in both ETFs and mutual funds have the option to reinvest dividends automatically to purchase additional shares of the fund, potentially compounding returns over time.
In addition to dividend income, mutual funds may also distribute capital gains to shareholders. Capital gains can result from the sale of securities within the mutual fund's portfolio at a profit. It’s important to note that capital gains distributions are taxable to the investor.
Comparing ETFs and Mutual Funds
Understanding the key similarities and differences between ETFs and mutual funds can help investors make informed decisions about which investment vehicle aligns best with their objectives and preferences. For example, ETFs typically have lower expense ratios and are traded on stock exchanges like individual stocks, providing intraday trading flexibility and tax efficiency. On the other hand, mutual funds are transacted at the end of the trading day and may offer actively managed strategies.
Constructing a diversified investment portfolio may involve incorporating both ETFs and mutual funds to achieve specific investment objectives and risk management goals.
