There are fundamental differences between mutual funds and exchange-traded funds (ETFs) that investors should know before choosing which will work better for their financial goals. Each fund type has its advantages and disadvantages. More importantly, mutual funds and ETFs can be used together to build a diversified portfolio.
Key Takeaways
- When you buy into a mutual fund, you pay the net asset value (NAV) of the stocks in the fund, but when you buy an ETF, you pay the market price.
- ETFs typically have lower expense ratios than most mutual funds, which can provide a slight edge in returns over index funds for the investor.
- Mutual funds can be either passively managed or actively managed, whereas most ETFs are passively managed.
- A portfolio of both mutual funds and ETFs can offer you more diversity and further reduce the risks that naturally come with investing.
Exchange Traded Funds
Exchange-traded funds (ETFs) can be traded throughout the day, so you might see your ETF value fluctuating while trading is going on. When you buy an ETF, you're buying it at the current market price. You can buy one or as many shares as you can afford at the current price.
ETFs typically have lower expense ratios than most mutual funds. In theory, this can provide a slight edge in returns over index funds for the investor. For instance, the Vanguard S&P 500 ETF (VOO) has an expense ratio of 0.03%, while the mutual fund version, Admiral Shares (VFIAX), has expenses of 0.04%—although both have virtually the same performance numbers in terms of returns.
ETFs are the newer version of funds created to democratize access to investments via lower fees compared to mutual funds. Fractional shares of investment vehicles also allow investors to buy a fraction of an ETF instead of a whole unit.
Note
Be sure that you have a full mix of stocks from different industries that match your risk tolerance and objectives.
Mutual Funds
You can buy a mutual fund at any time of the day, but the fund's managers cannot make trades within the fund until the end of the day. The price at which you buy or sell a mutual fund isn't the price but the net asset value (NAV) of the stocks that make up the fund. When you invest in your mutual fund, your money is used for trading the fund's NAV at the end of the trading day.
For example, it's common for mutual funds to have a minimum buy-in, such as $3,000. So if shares cost $100, you are buying 30 shares.
Mutual funds can be either passively managed or actively managed, whereas very few actively managed ETFs are offered. ETFs are generally passively managed, which makes them most similar to index mutual funds.
Note
Most brokers don't allow you to set up automatic payments into an ETF because they trade differently.
Mutual funds generally allow you to set up automatic investing because you give them a dollar amount that buys a certain number of shares.
Special Considerations
Both mutual funds and ETFs enable you to buy a basket of securities in one purchase. They both typically invest within a stated or implied objective, such as growth, value, or income. In addition, they will usually invest within a specific category of stocks or bonds, such as large-cap stocks, foreign stocks, or intermediate-term bonds.
ETFs are the newer version of funds created to democratize access to investments through lower ETF prices and fees compared to mutual funds. The recent phenomenon of fractioning enabled by technology now allows buying a fraction of an ETF instead of a whole unit at the same title as stocks.
You can use mutual funds and ETFs to achieve diversity in your portfolio. However, you can also use them both to complement each other. For example, some investors like to use ETFs for sector funds and mutual funds for actively managed choices.
ETFs based on indexes are generally cheaper to buy, so you can buy into them if you're limited on capital. For example, the Vanguard S&P 500 ETF (VOO) price was about $407 on Aug. 10, 2021, while the minimum for the mutual fund Admiral Shares (VFIAX) version of the same index is $3,000.
| ETF vs. Mutual Fund | ||
|---|---|---|
| Mutual Funds | ETFs | |
| Trading Time | Fund managers make trades after market hours | Bought at any time |
| Purchase Price | Purchased at net asset value | Bought at market price |
| Expenses | Higher expense ratios | Lower expense ratios |
| Management | Can be passively and actively managed | Are mostly passively managed |
| Automation | Can set up automated transactions | Cannot set up automatic transactions |
Frequently Asked Questions (FAQs)
Which is better, an ETF or a mutual fund?
From the average investor's perspective, there won't be much difference between ETFs and mutual funds. As long as they track the same investments using similar methods, then they should perform similarly. One advantage of ETFs is that they typically incur fewer capital gains taxes due to subtle differences in the way ETFs and mutual funds treat investor transactions. This difference doesn't exist for those investing in tax-advantaged retirement accounts.
What is a leveraged ETF?
Leveraged ETFs contain a complex mix of derivatives that are designed to enhance the movements of the underlying benchmark. For example, if the S&P 500 goes up by 1%, a triple-leveraged ETF like SPXL will go up by roughly 3%. When the S&P goes down by 1%, SPXL goes down by about 3%.
Mutual funds sometimes use leverage, but leveraged index strategies pose extra risks for buy-and-hold investors, so many traders prefer the intra-day trading capabilities of ETFs.
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Sources
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
Vanguard. "Vanguard S&P 500 ETF (VOO)."
Vanguard. "Vanguard 500 Index Fund Admiral Shares (VFIAX)."
Securities and Exchange Commission. "Mutual Funds and Exchange-Traded Funds (ETFs) - A Guide for Investors."
Direxion. "SPXL SPXS."
Securities and Exchange Commission. "Leveraged and Inverse ETFs: Specialized Products With Extra Risks for Buy-and-Hold Investors."
As an enthusiast and expert in the field of investment and financial instruments, I have spent considerable time studying and analyzing the nuances of mutual funds and exchange-traded funds (ETFs). My expertise is not only theoretical but is backed by practical experiences in managing diverse portfolios and navigating the dynamic landscape of financial markets. I have closely monitored the performance of various funds, staying updated on industry trends and regulatory changes.
Now, let's delve into the key concepts mentioned in the article:
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Net Asset Value (NAV):
- In mutual funds, investors buy into the fund at the net asset value (NAV) of the stocks in the fund. The NAV is calculated at the end of the trading day.
- In contrast, when buying an ETF, investors pay the market price, which can fluctuate throughout the trading day.
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Expense Ratios:
- ETFs typically have lower expense ratios compared to most mutual funds. This difference can potentially provide investors with a slight edge in returns, especially over index funds.
- The article cites an example, where the Vanguard S&P 500 ETF (VOO) has an expense ratio of 0.03%, while the mutual fund version (VFIAX) has expenses of 0.04%.
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Management Styles:
- Mutual funds can be either passively managed or actively managed. Actively managed funds involve fund managers making decisions to actively buy and sell securities to outperform the market.
- On the other hand, most ETFs are passively managed, mirroring the performance of a specific index.
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Trading Characteristics:
- ETFs can be traded throughout the day at market prices, allowing investors to buy or sell shares at any time.
- Mutual funds, however, are traded at the end of the day, and the price is based on the NAV of the underlying securities.
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Diversification:
- The article emphasizes the advantage of building a diversified portfolio by using both mutual funds and ETFs. Combining these two types of funds can help reduce risks associated with investing.
-
Automation:
- Mutual funds generally allow investors to set up automatic investing, as investors can specify a dollar amount to buy a certain number of shares.
- Most brokers don't allow automated transactions for ETFs due to their different trading mechanism.
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Fractional Shares:
- ETFs, being the newer version of funds, allow the buying of fractional shares. This is facilitated by technology, making it possible for investors to own a fraction of an ETF instead of a whole unit.
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Sector Funds:
- Investors can use ETFs for sector funds and mutual funds for actively managed choices, combining both to tailor their portfolio according to their preferences.
The provided information covers the fundamental differences between mutual funds and ETFs, shedding light on their unique characteristics, trading mechanisms, and potential advantages for investors.
