When constructing an investment portfolio, you’ll probably include a variety of stocks and bonds among the securities you purchase. Stocks and bonds can be purchased individually or as part of a bundle of securities known as a mutual fund or an exchange-traded fund (ETF).
Buying securities this way offers several potential advantages to investors — one of the biggest being instant diversification because mutual funds and ETFs contain not just one security, but many different individual securities. Funds are also run by professional portfolio managers attempting to beat the market, so investors have the benefit of expert management. But what is the difference between these two investment vehicles? They are often conflated, so we break down the similarities and differences.
What are ETFs and Mutual Funds?
Some people wonder whether mutual funds and ETFs are just different names for the same type of investing, or if they are different altogether. While there are similarities, they aren’t the same thing.
First, the similarities: Both mutual funds and ETFs consist of a basket of many different individual securities pooled together. So when you buy fund shares, you are effectively buying the shares or investing in the debt of hundreds, or even thousands, of different companies.
How Are Mutual Funds and ETFs Similar?
You might be surprised to learn just how similar mutual funds and ETFs are. Below we’ll break down a few of the most important similarities between these two types of funds.
As we mentioned, ETFs and mutual funds are both baskets that hold many underlying assets. Both types of funds can hold hundreds — or even thousands — of individual securities. Some ETFs and mutual funds hold only stocks, others hold only bonds, and some hold a combination of the two. Many of these funds are designed to track the performance of a particular index or sector, such as the S&P 500 or the information technology sector.
Exposure opportunity & diversification
Both mutual funds and ETFs make it easy to create a well-diversified portfolio with just a few investments. Rather than buying individual stocks and bonds, investing in funds allows you to instantly gain exposure to hundreds or thousands of individual securities.
You’re often able to access multiple sectors and parts of the economy with as little as one fund (or as many as a small handful). You can also gain exposure to niche markets like international stocks or small-cap companies without having to pick and choose individual securities.
Thanks to the diversification they provide to your portfolio, mutual funds and ETFs can both reduce your investment risk. When you invest in a single company, your entire portfolio’s success is tied to the success of that firm. And if that firm fails, so does your portfolio.
But with an ETF or mutual fund, you’ve spread your risk across hundreds of assets. And assuming you’ve included funds with both stocks and bonds, you’ve also reduced your downside risk to market changes that affect the performance of one asset class or the other.
Both mutual funds and ETFs are managed by professional portfolio managers whose job is to select the individual investments that will make up the fund. That’s not to say all of these funds are actively managed. On the contrary, many mutual funds and ETFs are tied to a particular market index or sector. As a result, they operate passively.
However, many mutual funds (and some ETFs) are actively managed by a fund manager. Rather than trying to match the performance of the market — as is the case with many passively managed funds — active fund managers seek to beat the overall market. Active management is often reflected with a higher expense ratio than you would find with passively managed funds.
What is the Difference Between an ETF and a Mutual Fund?
We’ve mentioned the similarities between ETFs and mutual funds, but it’s just as important to discuss the ways these two investments differ. Below we’ll share the three biggest differences between the two types of funds.
Where They Trade
Directly with the fund company
On major stock exchanges
How They Trade
At the close of the trading day
Throughout the day like stocks
How They’re Managed
Can be either actively or passively managed
Are usually passively managed (though they can be actively managed)
Like individual stocks, ETFs are listed on the major stock exchanges.
Therefore, ETFs cannot be bought or sold without having a brokerage account. Conversely, shares of mutual funds are traded directly with the fund company, so no brokerage account is necessary in order to buy and sell. You can simply place trade orders with the fund company or your financial advisor.
With ETFs, there is a bid price and an ask price — the price paid is usually somewhere between these. For example, suppose you want to invest $5,000 in an ETF at a final price of $45 a share. You’d need to place an order for 111 shares (111 x $45 = $4,995).
ETFs are traded throughout the day, just like stocks, with their prices fluctuating all day long.
As a result, they generally offer more trading flexibility as well as greater transparency. Mutual funds, on the other hand, are priced after the markets have closed at the end of the day when the fund’s net asset value (NAV) is calculated. So if you wanted to invest $5,000 in a mutual fund priced at $45 a share, you’d simply place a $5,000 order and receive approximately 111 shares at the end of the trading day.
ETFs are index funds that are passively managed. While some are also passively managed index mutual funds, others are actively managed.
While some mutual funds are also passively managed index funds, others are actively managed. As a result, ETFs usually feature lower expenses than mutual funds, which can result in higher after-tax returns. According to the Investment Company Institute (ICI), the average expense ratio of index ETFs is 0.21% while the average expense ratio of actively managed mutual funds is 0.78%. Even the less common actively managed ETFs tend to have lower expense ratios than mutual funds.
ETFs also tend to be more tax-efficient than mutual funds due to their low turnover, which minimizes taxable capital gains distributions. ETF securities don’t have to be sold in order to meet redemption requests from investors. This isn’t the case with mutual funds, where these redemptions may be subject to the capital gains tax for investors.
So which type of investment would be best for you — a mutual fund or an ETF? It depends on several different factors. But we generally advise against mutual funds due to some performance issues, unfavorable treatment of tax liabilities, and high costs.
Additionally, mutual funds are actively managed, and active fund managers rarely beat their benchmark over the long term.
However, while we tend to recommend against mutual funds, in a diversified portfolio, there may be a place for both mutual funds and ETFs. You should speak with your financial advisor about which type of investment is better suited to your investment strategy and goals.
Personal Capital’s dedicated financial advisors would be happy to talk through whether mutual funds vs. ETFs might work for your specific situation. You can schedule a free consultation after signing up for our financial dashboard.
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