3 Common Traits of ETFs and Mutual Funds
ETFs and mutual funds share some foundational traits. Here are the three biggest:
Professional Management
Both ETFs and mutual funds are professionally managed baskets of individual stocks or bonds. That is, fund managers select and manage the fund's holdings according to the guidelines set forth in the fund’s prospectus.
And what about the majority of ETFs and many mutual funds that are passive index funds? Portfolio managers make sure these funds don’t stray too much from their benchmark indices. In addition to benefitting from the manager’s investment expertise, you save time and effort when you choose professional management.
Wide Variety of Investment Options
There are thousands of ETFs and mutual funds designed to help investors pursue their financial goals, whether to gain global market exposure, generate income, or even access difficult-to-reach markets. You can invest broadly in a total market fund, more narrowly in a high-yield bond fund, in funds focused on sectors and industries, and just about everything in between.
Diversification
A single ETF or mutual fund can hold hundreds, or even thousands, of individual stocks or bonds. That means both vehicles offer the benefits of diversification in a single trade.
Where ETFs and Mutual Funds Differ
The closer you look at ETFs and mutual funds, the more traits they seem to share at first glance turn out to be significant differences.
Transparency
Both mutual funds and ETFs are required to disclose their holdings to investors on a regular basis, providing participants line of sight into ongoing performance.
But, the frequency of these communications differs:
- ETFs disclose their holdings on a daily basis, allowing investors an up-to-date, fully transparent view of their investments.
- Mutual funds normally release their holdings on a quarterly basis, so the information investors see may not always be up-to-date.
Liquidity and Trading
Both investment vehicles are generally considered to be liquid assets — that is, they can be easily bought and sold. But how ETFs and mutual funds are traded can impact liquidity.
ETFs have a liquidity edge because they’re priced and traded on an exchange throughout the day, while mutual funds are priced once per day after the market closes. That means investors can buy and sell ETFs at any time during market hours, while mutual fund investors must wait until the end of the day to buy or sell their shares.
But what’s really unique about ETFs — rooted in their unique creation and redemption process — is that two trading markets support their liquidity. In the secondary market, where most investors trade, ETF liquidity is provided by ETFs trading on the exchange. This is enhanced by the primary market liquidity of the ETF’s underlying securities, which can sometimes be even greater than an ETF’s secondary market liquidity.
Note that infrequently traded ETFs could have wide bid/ask spreads, meaning trading costs could be high. Mutual funds always trade without any bid-ask spreads.
Cost Efficiency
Both ETFs and mutual funds are considered cost-efficient investment options that benefit from economies of scale. As a fund grows in size, the costs associated with managing the fund can be spread out over a larger pool of investors.
Indexed ETFs and indexed mutual funds both typically charge management fees and other expenses, but these costs are generally lower than the fees associated with actively managed investments.
But ETFs generally have lower fees, or expense ratios, than mutual funds:
- ETFs’ average expense ratio is 0.5731
- Mutual funds’ average expense ratio is 0.8442
Of course, fees aren’t the only metric to measure costs. It’s important to consider the total cost of ownership (TCO) — the expense ratio plus trading and holding costs — for any investment.
In addition to reducing operating costs, which lowers your fees, the ETF’s unique creation and redemption process also works to reduce TCO. ETFs’ two trading markets provide added liquidity to support the quick reallocation of portfolios or to meet investor redemptions.
This doesn’t mean ETFs are free from expenses. If you buy and sell ETFs regularly, brokerage commissions and other associated trading costs can add up. You’ll find more information about the fees and expenses associated with these investment vehicles in the fund’s prospectus.
Tax Efficiency
Both ETFs and mutual funds are required to distribute capital gains and dividends to investors at least once a year. And those distributions can result in taxable events for investors.
But because ETFs have the ability to use in-kind redemptions to reduce or eliminate capital gains taxes, they distribute fewer capital gains than mutual funds. In 2022, just 3% of fixed income ETFs distributed capital gains compared to 15% of fixed income mutual funds.3 Taking a broad view, 4% of all ETFs distributed capital gains compared to 44% of mutual funds.4
That makes ETFs an inherently more tax-efficient investment vehicle.
Which Is Right for You?
Both ETFs and mutual funds provide a diversified investing strategy and offer an easy entry point to a wide range of markets for investors. Interestingly, that entry point, or the minimum investment requirement, may be one of the biggest differences between ETFs and mutual funds.
There is no minimum investment for an ETF. That’s because ETFs can be bought and sold in a single share, making them accessible to investors with smaller amounts to invest. But mutual funds typically require a minimum investment amount, which can range from a few hundred to several thousand dollars.
Understanding the similarities and differences between ETFs and mutual funds can help you choose the right investment vehicle for your portfolio. As you compare traits, deciding between ETFs and mutual funds depends more than anything on your personal investing preferences and your investment goals.
Bottom Line: ETFs and mutual funds are both useful investment products. And many investors build their portfolios with a combination of the two.
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