ETF vs. Mutual Fund: A Comprehensive Overview

Investors often seek a balance between growth and value when building their portfolios. This balance might include stocks, bonds, or even specific sectors such as technology, healthcare, or energy. A joint decision investors face is whether to choose a mutual fund or an exchange-traded fund (ETF) to meet their financial objectives.

Mutual funds and ETFs can include a range of investments, such as stocks, bonds, or commodities, and they follow similar regulations regarding what they can hold and how much of their holdings can be concentrated in one asset.

While mutual funds and ETFs can be valuable options for investors, key distinctions may make one better suited to specific financial goals.

Key Takeaways

• ETFs and mutual funds can both hold stocks, bonds, or commodities.
• While both may track indexes, ETFs are typically more liquid and cost-efficient since they trade on exchanges like individual stocks.
• Mutual funds offer the advantage of active management with greater regulatory oversight. Still, they typically come at a higher cost and only allow transactions once per day.

ETFs: An Overview

Exchange-traded funds (ETFs) are traded on stock exchanges like individual stocks. Most ETFs aim to track the performance of a specific index, such as the S&P 500, by creating a portfolio that mirrors the components of the index.

Since ETFs are usually passively managed, they tend to have lower expenses compared to mutual funds, especially those that also track indexes. The reason behind this cost efficiency is the nature of ETF trading. Investors buying and selling shares interact directly with each other on the exchange, meaning ETF managers have less involvement in the day-to-day transactions.

ETF providers strive to keep the ETF’s price as close as possible to the net asset value of the underlying index. This is achieved by adjusting the number of available shares, either by creating new or redeeming old ones as necessary.

Note: In January 2024, the Securities and Exchange Commission (SEC) approved the first Bitcoin ETFs based on the spot market. These ETFs are now traded on the NYSE Arca, Cboe BZX, and Nasdaq exchanges.

Mutual Funds: An Overview

Mutual funds are typically managed by financial institutions like Vanguard, T. Rowe Price, or BlackRock directly or through brokerage firms. Investors purchase mutual fund shares at the net asset value (NAV) based on the price at the market close. The shares are redeemed at the NAV when investors sell, following the same process.

Some mutual funds may impose penalties for early sales, typically within 90 days of purchase, which can amount to as much as 2% of the shares’ value.

While some mutual funds track indexes, most are actively managed. This means a team of professionals, often with extensive financial expertise, actively selects the investments in the fund’s portfolio. This active management incurs additional costs for research, company visits, and administrative tasks. As a result, mutual funds generally have higher operating expenses than ETFs.

Unlike ETFs, mutual fund investors pay capital gains taxes when they sell shares and when the fund distributes gains to them throughout the year.

Key Differences Between ETFs and Mutual Funds

ETFs

• Trading Flexibility: ETFs trade throughout the day on exchanges, just like stocks. Investors can buy and sell shares at market prices at any time during the trading session, not just at the end of the day.
• No Minimum Holding Period: Investors are not required to hold ETF shares for a specific length of time. This can be particularly beneficial for ETFs that track international assets, where the U.S. market may have already adjusted valuations.
• Real-Time Pricing: Since ETFs trade on exchanges, they reflect market conditions in real time, unlike mutual funds, which are priced once a day.
• Tax Efficiency: ETFs tend to engage in less internal trading, resulting in fewer taxable events. This tax efficiency makes ETFs appealing to investors aiming to minimize their tax burden.
• Lower Expense Ratios: ETFs generally have lower expense ratios than mutual funds due to their passive management style.

Mutual Funds

• Fractional Shares: Mutual funds can be purchased in fractional shares, meaning investors can contribute a fixed dollar amount rather than purchasing whole shares.
• Minimum Initial Investment: Many mutual funds have a minimum initial investment requirement, usually a base dollar amount, rather than being tied to the price of individual shares.
• Professional Management: For investors looking for active management, mutual funds offer the expertise of professional managers who make decisions about the portfolio’s composition.

Tax Implications for ETFs and Mutual Funds

ETFs

Taxes are typically only an issue for ETF investors when they sell their shares. Until that point, investors can delay paying taxes. Additionally, if an ETF pays dividends, those payments are taxable. However, the tax efficiency of ETFs, with fewer taxable events due to less internal trading, makes investors feel financially savvy and prudent.

Mutual Funds

Unless they use tax-favoured accounts like a 401(k), investors in mutual funds must pay taxes on the fund’s distributions of taxable gains, even if they are holding onto their shares and have not sold.

Open-End vs. Closed-End Funds

Both mutual funds and ETFs are considered open-ended, meaning the number of shares available can fluctuate as supply and demand dictate. This allows the funds to issue new or redeem existing shares as necessary. A closed-end fund, by contrast, offers a fixed number of shares and does not continuously issue new ones after the initial offering.

The Bottom Line

ETFs and mutual funds offer investors access to diversified portfolios of individual securities, such as stocks and bonds. This diversification helps reduce risk compared to investing in single securities.

While both options are valuable, each has its strengths and weaknesses. ETFs are more cost-effective and offer real-time trading, making them attractive to investors seeking lower fees and flexibility. On the other hand, mutual funds provide the benefit of active management and professional oversight. However, they come with higher costs and are less flexible regarding trading.

Ultimately, the choice between an ETF and a mutual fund comes down to an investor’s goals, preferred management style, and fee tolerance. Both options can play an essential role in a diversified portfolio. Still, investors must understand the critical differences before making their decision.