When it comes to investing, mutual funds and exchange-traded funds (ETFs) are two of the most popular options for building a diversified portfolio. Both investment vehicles pool money from multiple investors to buy a mix of stocks, bonds, or other assets. Despite their similarities, mutual funds and ETFs differ in several key ways, including how they are traded, their fee structures, and tax efficiency. Understanding these differences can help investors determine which option best aligns with their financial goals.
One of the primary distinctions between mutual funds and ETFs is how they are bought and sold. Mutual funds trade only once per day, with transactions processed after the market closes. The price at which investors buy or sell shares is determined by the net asset value (NAV), which is calculated based on the total value of the fund’s assets at the end of the trading day. In contrast, ETFs trade on an exchange throughout the day, just like individual stocks. Their prices fluctuate based on supply and demand, allowing investors to buy and sell shares at market prices in real time. This intraday trading feature makes ETFs more flexible, as investors can react quickly to market movements, whereas mutual fund investors must wait until the end of the day for their transactions to be executed.
Another major difference lies in their management style. Mutual funds can be actively or passively managed. Actively managed mutual funds employ professional fund managers who select securities with the goal of outperforming the market. These funds tend to have higher fees due to management costs but may provide the potential for higher returns. Passively managed mutual funds, also known as index funds, simply track a market index, similar to most ETFs. ETFs, on the other hand, are predominantly passive investments designed to replicate the performance of a specific index, such as the S&P 500 or the NASDAQ-100. While actively managed ETFs do exist, they are less common than their mutual fund counterparts.
Cost structure is another important factor when comparing mutual funds and ETFs. Mutual funds often have higher expense ratios, particularly if they are actively managed, with fees typically ranging from 0.5% to 2% or more per year. Some mutual funds also charge sales loads, which are commissions paid when buying or selling shares, as well as 12b-1 fees, which cover marketing and distribution costs. ETFs generally have lower expense ratios, especially those that track indexes, with fees ranging from 0.03% to 0.5%. Unlike mutual funds, ETFs do not charge sales loads since they are traded directly on an exchange. However, investors may face brokerage commissions when buying or selling ETF shares unless using a commission-free brokerage. Another cost consideration for ETFs is the bid-ask spread, which is the difference between the buying and selling price of the ETF at any given time.
Tax efficiency is another area where ETFs often have an advantage over mutual funds. Mutual funds distribute capital gains to investors at the end of the year, which can trigger tax liabilities even if the investor did not sell any shares. This is particularly relevant for actively managed mutual funds, where frequent buying and selling of securities within the fund can generate taxable gains. ETFs, by contrast, use an “in-kind” creation and redemption process, which allows them to minimize taxable events. As a result, ETFs typically do not distribute capital gains, making them a more tax-efficient investment choice for taxable accounts.
Investment flexibility also sets these two options apart. Mutual funds often require a minimum investment, which can range from $500 to $3,000 or more. However, many mutual funds allow for automatic investment plans, enabling investors to make regular contributions with smaller amounts. ETFs do not have minimum investment requirements, making them more accessible for those investing with smaller amounts of capital. Because ETFs trade like stocks, they offer greater liquidity, allowing investors to buy and sell shares at any time during market hours. This makes ETFs particularly appealing to those who want more control over their trades.
When deciding between mutual funds and ETFs, investors should consider their personal investment strategy, preferences, and financial goals. Mutual funds may be a better choice for those who prefer a hands-off approach and are comfortable with higher fees in exchange for active management. They are also a good option for investors who want to set up automatic contributions for long-term investing. On the other hand, ETFs are ideal for those who seek low-cost, tax-efficient investments with the flexibility to trade throughout the day. Their accessibility and lack of minimum investment requirements also make them a great option for new or small-scale investors.
Both mutual funds and ETFs offer valuable benefits, and choosing between them ultimately depends on an investor’s financial objectives and preferred investment style. Those seeking professional management and a structured investment plan may find mutual funds more suitable, while those who prioritize flexibility, lower fees, and tax efficiency may prefer ETFs. By understanding the key differences between these investment vehicles, investors can make informed decisions to build a portfolio that aligns with their long-term financial goals.
The commentary on this blog reflects the personal opinions, viewpoints and analyses of the author, Katherine Sullivan, and should not be regarded as a description of advisory services provided by Foundations Investment Advisors, LLC (“Foundations”), or performance returns of any Foundations client. The views reflected in the commentary are subject to change at any time without notice. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security, or any security. Foundations manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary.
