ETF vs. Mutual Fund: What’s the Difference?

What Are Mutual Funds?

Mutual funds are a type of investment that allows shareholders to pool their money together with many other investors' to buy into a diverse portfolio of bonds and other securities. Mutual funds are overseen by investment experts registered with the federal Securities and Exchange Commission (SEC). They're typically actively managed, which means the fund's portfolio is invested strategically with an aim to beat the market. There are also mutual funds set up to track a specific market index, and these passively managed funds tend to charge lower fees.

Mutual fund shares represent partial ownership of the mutual fund's portfolio and its returns. You can buy and sell shares of a mutual fund directly through the fund, but many investors buy them through brokers.

What Are Exchange-Traded Funds (ETFs)?

Similar to mutual funds, ETFs are an investment that pools together the money of many investors into a portfolio of stocks, bonds and other assets. Unlike mutual funds, you can buy and sell shares of ETFs on the market during trading hours, similar to how you buy stocks.

ETFs are typically passively managed, and most ETFs are index funds. Because ETFs aren't usually actively managed, they also tend to charge lower fees than mutual funds.

Similarities Between Mutual Funds and ETFs

Both mutual funds and ETFs are instruments investors can use to create a diverse portfolio that exposes their money to a balanced amount of risk. Apart from that, ETFs and mutual funds have this in common:

• SEC-regulated: Both mutual funds and ETFs are regulated by the SEC, and are managed by SEC-registered investment professionals. That means both types of funds have to comply with certain rules, including standards for diversification, transparency and how the fund values its holdings.
• Fees: Both mutual funds and ETFs charge fees, though they likely differ in amount. Shareholders must pay any management fees and other transaction fees or commissions regardless of how the fund performs.
• Risk: All investments come with some level of risk. The aim of investing diversely is to reduce risk by broadening your exposure to many different assets, but there's no guarantee you'll make money. One way to understand the potential risks and rewards of a mutual fund or ETF is to research its historic performance and read the fund's prospectus.

Differences Between Mutual Funds and ETFs

Here are the key differences between mutual funds and ETFs:

• Trading: While both are fairly liquid, ETFs are more liquid than mutual funds because they can be traded at any point during the day while the market is open. You can buy and sell ETF shares through a brokerage at market price, similar to trading stocks. A share's market price may be at a premium or at a discount to the fund's net asset value (NAV). NAV is calculated by subtracting a fund's liabilities from its assets and dividing by the total number of shares—in other words, it's a standardized valuation of a fund's share value. When you buy shares of a mutual fund, you're charged based on the fund's NAV calculated at the end of the trading day.
• Management: While ETFs can be actively or passively managed, most ETFs are passive, index-tracking funds. Mutual funds can also be structured to match market indexes, but most mutual funds are actively managed.
• Costs: All else being equal, ETFs usually charge lower fees than mutual funds due to how they're managed. Mutual funds can charge flat or percentage-based management fees as well as more hidden transaction fees. ETFs also charge fees for operating expenses, and typically also commissions when you buy and sell shares. Investors also need to be aware of an ETF's bid-ask spread, a term for the difference between the highest amount an investor is willing to pay for an ETF and the lowest price the seller will accept. Bid-ask spreads can be thought of as a type of hidden fee; a wider bid-ask could eat into the potential returns an investor may anticipate if they sold their ETF shares.
• Taxes: Gains from both ETFs and mutual funds are subject to taxes. ETFs are structured to minimize taxes by avoiding realized gains. Note that these tax advantages aren't relevant if you're investing through a retirement account such as a 401(k).

ETF vs. Mutual Fund: Which Should You Choose?

Whether to invest in mutual funds or ETFs comes down to what you're investing for and the features that are most important for you.

Reasons you might choose to invest in ETFs over mutual funds could include the desire to have more active control, the ability to make intraday trades, a preference for index funds or if you want to invest in an asset with minimal taxes outside of your retirement accounts.

On the other hand, you might find that mutual funds are a better fit for investing toward long-term goals. They require little active management from the investor, and the wide range of mutual fund options available means you can choose a mutual fund that works best for you—then relax knowing the work is being done for you.

The Bottom Line

Mutual funds and ETFs both offer investors the opportunity to invest across a range of assets, thus mitigating some of the risk of putting all your eggs in one basket. That said, there's always risk in investing. Funds you hold in either of these assets aren't insured by the FDIC, and you can lose money by investing in mutual funds and ETFs.

Regardless of the specific assets you're considering, it's always important to know your goals before you decide to invest. If you need help setting goals and choosing assets that align with them, consider reaching out to a financial advisor.