Exchange-traded funds (ETFs) and mutual funds are both SEC-registered investment vehicles that offer investors a convenient way to build a diversified portfolio. Both are professionally managed and offer investors slices of the portfolio. Both can hold hundreds or thousands of securities. Both are not FDIC insured, which means an individual can lose their money.
For decades, ETFs and mutual funds have provided retail and institutional investors an efficient way to invest in stocks, bonds and other asset classes. Yet there are key differences.
Differences Between ETFs and Mutual Funds
While there are plenty of similarities between ETFs and mutual funds, let’s start with some key differences.
How to Buy Mutual Funds and ETFs
The biggest difference between mutual funds and ETFs is how they’re purchased and sold. Mutual funds transact once per day, with all investors selling or buying shares at the same closing price. ETFs trade throughout the day on public exchanges, with many shares exchanging hands at various prices as buyers and sellers react to changes in the market.
Data on Holdings
Mutual funds are required to report the total value of their portfolio once per day after the stock markets close. The fund then figures out how many shares they have and what each share is worth based on the total value. This is what is referred to in the industry as the Net Asset Value, or NAV. When investors buy or sell a share of the mutual fund, they transact at that NAV at the end of the day.
Meanwhile, ETFs have to report their holdings on a daily basis. The price of the ETF fluctuates throughout the day based on market conditions and the value of the ETF’s underlying holdings.
Passive vs Active
ETFs tend to be considered “passive investments.” That’s because investors are not necessarily making active trades but rather tracking an underlying index. However, actively managed ETFs have also cropped up, since the first ETF was launched in 1993.
Meanwhile, with mutual funds, it’s common to find an active fund manager who makes decisions on which holdings to buy and sell.
Fee Differences Between ETFs vs Mutual Funds
Mutual funds tend to charge different types of fees to cover their business costs. ETFs generally charge lower fees. Compared to active investing, passive investing usually incurs lower fees since they track a particular index, like the S&P 500 Index.
Tax Implications of ETFs vs Mutual Funds
You may get better tax efficiency with ETFs, because you are not buying or selling as much with them. There are fewer transactions to tax and ETFs are generally tax efficient given their unique creation and redemption mechanism that they employ.
You’ll have to pay capital gains taxes and dividend income taxes, but ETFs have a lower tax requirement than mutual funds. Due to the unique structure of ETFs, they’re often able to reduce the amount of capital gains they distribute each year relative to a comparable mutual fund.
Lower Initial Investment
As a general rule, mutual funds tend to require a higher initial investment. ETFs, on the other hand, allow investors to invest in as little as a single share. In some cases, brokerage firms allow investors to even buy ETF fractional shares, slices of a whole stock in an ETF.
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Types of Mutual Funds
The first mutual fund was launched in the 1970s by the late Jack Bogle of Vanguard. Since then the investment type has steadily increased in popularity. They account for tens of trillions of dollars.
Here are some of the different types of mutual funds:
Load Mutual Funds
Load mutual funds charge a sales commission that’s paid to a financial professional or broker who helped the investor decide on which mutual fund to purchase.
There are typically two types of load mutual funds: Front-end load funds, which means the fee is paid when the mutual fund is purchased, and back-end load funds, which means the fee is paid when the mutual fund purchase is redeemed. Generally, back-end load funds charge higher fees.
No-Load Mutual Funds
Investors could look for a “no-load” mutual fund, which means the shares are bought and sold without charging commissions.
This plan may be best for investors who plan to do a lot of trading. If investors have to pay a commission charge every time they buy or sell a security, frequent trading will reduce returns. However, the expense ratios for no-load mutual funds are often higher.
Active vs Passive Mutual Funds
Most mutual funds are actively navigated by experienced money managers who steer the fund and invest in companies they believe will lead to outperformance. However, there are also passive mutual funds that track indices, similar to the way ETFs do.
Open-Ended Funds
Purchases and sales of fund shares typically happen directly between an investor and the fund company. As more investors buy into the fund, more shares are added, which means that the number of eventual fund shares can be nearly unlimited.
However, the fund must undergo a daily valuation by law, which is called marking to market (see a deeper dive on this below). The result of this process is a new per-share price, which has been adjusted to sync with any changes in the value of the fund’s holdings. An investor’s share value is not affected by the quantity of outstanding shares.
Closed-End Funds
Unlike open-ended funds, closed-ended funds (CEFs) are finite and limited. Only a specific number of shares are issued and no further shares are expected to be added.
The prices of close-ended funds are influenced by the NAV of the fund, but are ultimately determined by the demand investors have for the fund. Since the amount of shares is fixed, the shares often trade above or below the NAV. If the fund is trading above the NAV (what it’s really worth), it’s said to be trading at a premium; if trading below the NAV, it’s said to be trading at a discount.
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Different Types of ETFs
ETFs are just one class of funds within the broader exchange-traded product (ETP) universe. Here’s a closer look at the different types of ETPs and ETFs.
Exchange-traded notes (ETNs)
Exchange-traded notes (ETNs) are usually debt instruments issued by banks that seek to track an index.
Leveraged ETFs
Leveraged ETFs use derivatives to amplify returns from a fund. For instance, if an underlying index moves 1% on a trading day, a regular ETF tracking the index would also move 1%. However, a leveraged ETF could move 2% or 3% depending on whether it’s double levered or triple levered.
Inverse ETFs
Inverse ETFs are similar to shorting a stock. Investors can use inverse ETFs to bet that the price of a market or stock sector will go down. So if the underlying goes down 1% on a given day, the inverse ETF will go up 1%.
Thematic ETFs
Thematic ETFs tend to focus on a slice of the stock market and follow a specific trend. Thematic ETFs that have cropped in recent years include those that cover renewable energy, the gig economy, or even pet care.
The major pros and cons of thematic ETFs include capturing a specific trend that appeals to an investor, as well as being too narrowly focused.
The Takeaway
Both ETFs and mutual funds allow investors to pool funds with other investors’ funds to ultimately buy and sell baskets of securities in the market. The aim is portfolio diversification and reducing risk compared to investing in a single company. If a person were to put all of their money into one company instead, their investment isn’t diversified because their fortunes are tied to that single company.
Investing in both ETFs and mutual funds, or a combination of both (or either) will depend on an individual investor’s preferences. Not all investments are right for each portfolio, and some research is necessary to see what’s right for you.
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