Mutual funds and ETFs (exchange-traded funds) are two of the most popular ways for investors to build diversified portfolios. While they share some similarities, mutual funds and ETFs have some key differences in how they operate, fees and taxes, and investment strategies.
This blog post will compare mutual funds vs. ETFs on these factors to help readers decide which investment vehicle may be better suited for their needs.
Both mutual funds and ETFs offer the benefits of instant diversification by investing in a variety of assets. Professionally managed mutual funds pool money from many investors to construct a portfolio of stocks, bonds, and other securities.
ETFs also offer a basket of pre-selected securities but trade more like individual stocks on exchanges. While mutual funds have been around for decades, ETFs emerged in the 1990s and have gained tremendous popularity over the past 10-15 years.
How They Work
Mutual funds and ETFs have some key structural differences in how they operate:
Mutual Funds
- Professionally managed portfolio of stocks, bonds, and other securities
- Investors purchase shares of the mutual fund
- Trades happen once per day after markets close at the fund’s Net Asset Value (NAV)
- Open-end structure means number of shares is flexible based on demand
- Minimum investment amounts required to purchase shares
ETFs
- Basket of securities like a mutual fund but trade on exchange like a stock
- Trades throughout the day at fluctuating market prices like stocks
- Created/redeemed based on supply/demand in primary market between institutions
- No minimum investment amount – can trade tiny fractions of a share
The fact that mutual funds trade only once per day while ETFs can be traded all day long like stocks is a major operational difference between these two investment vehicles. This impacts fees, taxes, and trading flexibility as we’ll explore more below.
Costs and Fees
The costs and fees charged by mutual funds and ETFs can have a big impact on long-term returns. Here’s an overview of the common fees associated with each investment vehicle:
Mutual Fund Fees
- Expense ratio – Annual fee charged as percentage of assets to cover operating costs
- Front-end load – Upfront sales fee when purchasing shares
- Back-end load – Redemption fee when selling shares
- Mutual fund expense ratios typically range from 0.5% to over 1%
ETF Fees
- Expense ratio – Annual operating fee but often lower than mutual funds
- Average ETF expense ratio is around 0.44%
- Brokerage commission – Online brokers charge per trade commissions to buy/sell ETFs
The management fees and trading commissions for ETFs are often lower than actively managed mutual funds. Passive index ETFs in particular have very low expense ratios. However, frequent ETF trading can result in higher total costs from commissions.
Tax Efficiency
Taxes are another area where mutual funds and ETFs differ.
Mutual Funds
- Managers buy and sell securities within the fund throughout the year
- This generates capital gains that get passed on to investors
- Investors must pay annual taxes on these capital gains distributions
ETFs
- Use in-kind transfers of securities to authorized participants
- Less buying/selling of securities inside the fund
- Fewer capital gains generated and less taxes for investors
- More tax efficient structure than actively managed mutual funds
ETFs are generally more tax efficient than mutual funds. Investors only pay capital gains taxes when they personally sell ETF shares at a profit. With mutual funds, capital gains taxes must be paid every year even if the investor hasn’t sold any shares.
Investment Strategies
Mutual funds and ETFs take different approaches to managing investments:
Mutual Fund Strategies
- Actively managed – Fund managers pick securities to try beat the market
- Index funds – Passively follow market indexes like the S&P 500
- Sector specific – Invest in particular assets class or industry
- Various stock/bond allocations – Appeal to conservative vs. aggressive investors
ETF Strategies
- Predominantly passively managed index funds
- Cover broad market indexes or specific sectors
- Asset class/factor-based – Bonds, commodities, dividends, etc.
- Trading flexibility – Can buy/sell anytime during trading day
While mutual funds focus more on active stock picking or passive indexing, ETFs offer wide exposure to markets, sectors, and factors. ETFs lend themselves better to tactical trading strategies as well given their intraday liquidity.
Performance Comparison
When looking at returns, mutual funds and ETFs have delivered varying results:
- Over the past 10 years, the average actively managed mutual fund has slightly underperformed its benchmark index
- Passive index mutual funds and ETFs have matched their benchmark returns before fees
- After fees, broad market ETFs have slightly outperformed comparable index mutual funds
Here are average annual returns over key time periods:
| Fund Type | 1 Year | 1 Year | 10 Year |
|---|---|---|---|
| Actively Managed Mutual Funds | 6.1% | 8.4% | 9.8% |
| Index Mutual Funds | 7.2% | 9.1% | 10.4% |
| Broad Market ETFs | 7.4% | 9.3% | 10.6% |
While past performance doesn’t guarantee future results, index ETFs have historically delivered higher returns than actively managed mutual funds while also saving on fees.
Key Differences in Summary
To recap, here are some of the major ways that mutual funds and ETFs differ:
Fees
- ETFs offer lower expense ratios than actively managed mutual funds
- But ETFs have brokerage commissions to trade while mutual funds don’t
Taxes
- ETFs are more tax efficient overall due to lower capital gains distributions
Trading
- ETFs can be traded anytime like stocks while mutual funds trade once a day
- ETFs offer more flexibility for tactical trading
Strategies
- Mutual funds focus on active and passive, stocks and bonds
- ETFs offer passive index-based strategies across various assets
While mutual funds and ETFs share similarities as diversified baskets of securities, their differences in fees, taxes, trading, and strategies give investors options to suit different preferences and needs.
Conclusion
Mutual funds and ETFs offer investors convenient ways to construct diversified portfolios. While mutual funds focus more on active stock picking or passive indexing, ETFs provide wide exposure to markets, sectors, and factors in a low-cost, tax-efficient, and flexible trading structure.
When choosing between mutual funds vs. ETFs, investors should consider factors like:
- Desired investment strategy and assets
- Impact of fees and taxes over time
- Preferred trading frequency and features
Passive index ETFs have compelling advantages for buy-and-hold investors focused on minimizing costs and taxes. But mutual funds, particularly actively managed ones, can provide experienced stock pickers trying to beat the market.
Overall, ETFs appear better suited for cost-conscious investors pursuing broad market returns. But mutual funds offer active approaches for those seeking targeted stock and sector exposure. The merits of each vehicle ultimately depend on an investor’s specific financial situation and investment philosophy.
