The difference between an ETF vs. a mutual fund may seem trivial, as both are available as part of professionally-managed investment portfolios.
But ETFs often are superior because of lower costs and better tax efficiency, especially if you’re investing outside of a retirement account.
In this article, I’ll explain the differences between ETFs and mutual funds and offer advice on how you can apply those differences to your own investing decisions.
Table of Contents
- ETF vs. Mutual Fund: Similarities and Differences
- Passive vs. Active Fund Management: Why It Matters
- ETFs vs. Mutual Funds: The Tax Difference
- Mutual Fund Advantages
- ETF Advantages
- Fund Types: ETFs and Mutual Funds
ETF vs. Mutual Fund: Similarities and Differences
|Investing Style||Often passive||Often active|
|How It Trades||Open market||Via fund's parent company|
|Taxes||More efficient*||Less efficient*|
|Expense Ratios||Often less expensive||Often more expensive|
|Trade Types||Complex types allowed||Only simple buy/sell orders|
|Automated Investing||Usually not allowed||Usually allowed|
*Applies only to investing outside of a retirement account.
Figuring out the difference between investing in an exchange-traded fund (ETF) vs. a mutual fund can be tricky. They’re similar in so many ways. But what appear to be, at first glance, a few subtle differences — in costs and tax implications — could make a huge impact on your returns.
In either case, you’re giving your money to a professional fund manager to invest on your behalf.
These managers aren’t investing your dollars willy-nilly. They’re typically investing in some combination of stocks and bonds, but all sorts of fund types exist. Before diving into a fund, you can read a prospectus that lets you know the fund’s strategy, portfolio, performance history and much more.
ETFs and mutual funds can be passive (example: index funds) or active. Both types of funds offer more diversification than buying an individual stock.
However, ETFs trade on the open market, whereas you’ll need to buy shares of a mutual fund through the fund’s parent company. This is just one of the reasons that ETFs are more tax efficient.
The two biggest points to understand when it comes to ETFs vs. mutual funds:
- Money expert Clark Howard prefers low-cost investments that charge fewer fees. Clark has maintained for years that there’s a strong correlation between how much you pay in investment fees and how much money you’ll be able to accumulate for retirement. ETFs often charge fewer fees than mutual funds. The ETF and mutual fund versions of broad-market index funds can be nearly indistinguishable in terms of fees.
- It’s usually better to invest in an ETF if you’re doing so outside of a retirement account (such as a 401(k) or IRA), primarily for tax reasons.
Passive vs. Active Fund Management: Why It Matters
Each person’s attitude and approach to investing is different. Some are content to ride the market and get average returns for a long period of time.
Others are itching to find any sort of edge to outperform, say, the S&P 500. In the case of funds, that involves chasing trends and momentum or making outsized bets on a smaller number of companies.
That’s essentially the difference between “passive” and “active” funds.
Can you guess which one that Clark likes?
“Remember that the goal should be financial security for your life. And you do that not by betting the farm on one company,” Clark says. “I want you betting on the future of capitalism, not the future of a single company.”
What Is a Passive Fund?
The classic example of a passive fund is an index fund. An index fund tracks an underlying financial index such as the S&P 500.
An index fund manager doesn’t need a team of analysts, stacks of data or in-person interviews with dozens of company execs to determine how to invest your money. He or she simply takes the pool of invested money and puts it into the stock of the companies inside the index.
As you can imagine, this style of investing is less expensive and involves less frantic trading. In a word, it’s passive. That means the fund manager is charging you less in fees (or “expense ratios”). And it may mean less realized gains (selling profitable investments), which the government taxes.
The biggest downside of a passively-managed index fund is that your gains are capped. You’re not going to beat the market if you’re tracking the market.
ETFs and mutual funds can be passive or active. Index funds come in both flavors. However, ETFs are more commonly passive, while mutual funds are more commonly active.
What Is an Active Fund?
Why would you leave all your money in a total stock market index fund when you have the freedom to hand-select companies that you believe will beat the market?
Better yet, if you were to hand over your money to a team of professional investors with astute math and economic abilities and a devotion to identifying those companies, wouldn’t that be better than investing in a passive index fund?
Usually not. There are legions of well-known research studies that show how difficult it is to outperform the market long-term.
One reason why? Constantly rotating your portfolio holdings costs money, as do all the resources it requires to identify investment targets in an active fund. Expense ratios are exponentially higher, which raises the bar that fund managers must clear.
It’s also not easy to beat the market consistently: If a company outperforms one year (or even for a number of years), it becomes harder to continue outperforming.
Active funds give you the chance to capture outsized, market-beating returns. But in many cases, your bottom-line ROI will be worse.
ETFs vs. Mutual Funds: The Tax Difference
(If you’re investing through a retirement account, you can skip this section or at least read it while sipping your favorite drink and watching the sunset.)
You can buy a mutual fund or you can buy an ETF and you aren’t going to pay any taxes while your funds are inside your retirement account.
But if you’re planning to invest outside a retirement fund, you need to pay careful attention to the tax differences between ETFs and mutual funds. The bottom line is that ETFs are more tax efficient.
They trade just like stocks: When the market is open, there’s a bid (the maximum price someone is willing to pay) and an ask (the minimum price someone is willing to sell). So when you buy an exchange-traded fund, you buy directly from another investor.
With mutual funds, you send buy orders to the fund manager. That person waits until the end of each business day, figures out the price of the fund’s shares and then executes all the orders (including yours) at that price.
Investors constantly buy into and sell out of mutual funds. Because they aren’t buying and selling to each other directly, the fund manager is constantly buying and selling portfolio holdings. That alone generates more taxable capital gains, especially during bull markets.
Mutual funds also are required to distribute capital gains. That means that, even if you elect to reinvest those capital gains, the IRS will tax you on them.
So if you’re going to be on the hook for taxes on any realized investment gains, ETFs are preferable.
Mutual Fund Advantages
If you’re trying to choose ETF vs. mutual fund, it may help to know some of the best mutual fund characteristics:
- Can be automated. Most companies that sell mutual funds let you make automatic investments or withdrawals monthly, quarterly or annually. Clark is a huge fan of this feature. It’s uncommon to be able to automate ETF investments, although Robinhood does allow its users to do so.
- Not as easy to sell. Trading platforms have become friction-free for better or worse. It’s extremely easy and fast to buy and sell stock (or in this case, shares of an ETF). It’s not difficult to sell mutual fund shares, but it’s not instant and you can’t name your price. If you’re investing for the long term, this is a feature rather than a bug, as you shouldn’t be relying on your investments to fund financial emergencies.
- Little trading knowledge required. With ETFs, you have to navigate the bid/ask spread I mentioned earlier. If the ETF is popular and there’s a lot of trading volume around it, the spread should be low, so you probably won’t pay much of a premium. However, in some cases, if you make a market order on an ETF, you could be paying a premium compared to what the underlying investments are worth. If that all sounds like a mind twister, just know that you don’t have to worry about any of that with mutual funds.
- Instant diversification. Outsourcing your investing through a professional portfolio manager, particularly in a well-diversified mutual fund, is a simpler, faster way to spread your investing dollars across a wider range of companies than investing in an individual stock. This is the case for mutual funds and ETFs.
Here are some of the best characteristics of ETFs:
- More liquid. You can buy and sell an ETF any time the market is open. You have control over the price as well, which you don’t get when you buy into a mutual fund. In other words, you can put in a limit order and decide to buy only at that price. Or you can see what the current lowest price is from those willing to sell.
- Usually more cost-effective. ETFs tend to be less expensive than mutual funds, at least in part because more ETFs are passively managed. Even when there’s an ETF and a mutual fund of the same version, the ETF often charges a smaller expense ratio.
- Less of a tax burden. ETFs are more tax-efficient than mutual funds, which is important if you’re investing within a taxable account.
- Lower investment minimums. Many mutual funds require $1,000+ in order to invest. You can generally buy a share of an ETF for much less than that. Robinhood even allows $1 fractional shares on ETFs.
- Better for short-term trading. Investors can buy and sell ETFs throughout the day. ETFs also can focus on narrow market niches. They’re much friendlier for short-term positions than mutual funds. As an example, some traders use them to essentially make short-term bets on specific sectors (such as an ETF that focuses on the largest banks). Clark says that frequent trading can create tax issues.
- Equal or greater diversification. Because ETFs are commonly index funds, ETFs usually give you at least as much diversification as mutual funds.
Fund Types: ETFs and Mutual Funds
ETFs and mutual funds generally offer the same types of funds with a few minor differences.
Clark traditionally recommends two approaches. First, he thinks that target date funds are the best option for most people. Second, if you want to do something a little more advanced than a target date fund, he recommends splitting your investment portfolio between total stock market, bond and international index funds.
Here are the fund types that are available within the ETF and mutual fund families:
- Target date funds. This is Clark’s most frequent investment recommendation. Target date funds are mutual funds, not ETFs. They’re typically an option you’ll find inside a 401(k) plan or Individual Retirement Account (IRA). Clark calls them the “easy button” for investing, as you can put your money into them and forget them until you’re ready to retire.
- Index funds. Clark is also a big fan of index funds. These track an underlying financial index such as the Russell 2000. They’re passively managed so they tend to be inexpensive, diversified and well-suited for retirement investing.
- Equity funds. Equity is another word for stock. These funds invest in the stock market. There are a variety of options, including the size of the companies that the fund manager targets and whether the fund manager invests for value or growth.
- Bond funds. There are multiple choices within the world of bonds as well. Bonds are considered “fixed” income — lower on the risk spectrum but with less potential for big returns.
- International funds. These are just like equity funds, but they buy stock of non-U.S. companies.
- Asset allocation funds. These funds offer a blend of stocks, bonds and even some other asset types. You’ll see a lot of these types of funds as ETFs offered by robo-advisors.
It’s a challenge to give advice on ETFs vs. mutual funds without knowing your specific circumstances.
However, there are some easy, templated decision points.
If you’re investing inside a retirement account, Clark’s first recommendation is that you invest in a target date fund. If you’re investing outside of a retirement account, give strong consideration to an ETF that’s an index fund.
As with any investment decision, do your own research and try to apply these frameworks in the way that fits you and your circumstances the best.