Mutual funds are one of the oldest forms of investment, with the first modern fund dating back to 1924. Exchange-traded funds, on the other hand, have boomed in popularity relatively recently. At their core, mutual funds and ETFs share many characteristics. The actual structure of mutual funds and ETFs differs, however, both in terms of how you can buy them, how much they cost and how they invest. Here’s a look at the similarities and differences between ETFs and mutual funds, along with suggestions as to how you can choose the better investment for your portfolio.
What Is a Mutual Fund?
When you buy a mutual fund, your money is commingled with other investors and invested according to specified investment rules by a professional manager. Shares are bought directly from the issuing fund company and are priced once daily, at the close of business. Mutual funds don’t charge commissions, but they might have sales loads, either to buy or to sell. All mutual funds have ongoing expenses that are passed through to investors in the form of an expense ratio.
Related: 20 Best Mutual Funds
What Is an ETF?
As the name suggests, exchange-traded funds trade on stock exchanges. Rather than buying shares from a mutual fund company, you buy and sell ETF shares just like a stock. You’ll pay a standard stock commission to buy ETF shares, but you won’t owe any type of sales load. Just like with mutual funds, ETFs have ongoing costs expressed in the expense ratio.
What Is an Index Fund?
An index fund tracks the performance of a specified index. For example, the Vanguard 500 Index Fund attempts to replicate the performance of its underlying index — the Standard & Poor’s 500 index. You can find an S&P 500 fund in the form of either a mutual fund or an ETF, along with other index trackers.
Pros and Cons of Mutual Funds
Mutual funds carry both pros and cons. Whether the pros outweigh the cons will depend on what you’re looking for as an investor.
- Active professional management
- Designed for long-term investment, which can help prevent overtrading
- Free exchanges to other funds in the same family
- Can have a high-cost structure
- Hard for active funds to outperform the market
- Can only execute trades at end of the market day
Pros and Cons of ETFs
Just like with mutual funds, exchange-traded funds are more appropriate for some investors than others. Here’s a look at the major plusses and minuses of owning an ETF:
- Can buy or sell at any time market is open
- Can have low costs
- Tax efficiency
- Index strategies have limited chance of outperformance
- Passive strategies have no active management
- Commission costs can add up
- Easy access might lead to overtrading
How to Choose Between Mutual Funds and ETFs
Your choice of investment strategies can help define if you are a mutual fund or an ETF investor. Active traders would be better suited buying ETFs. Because ETFs trade throughout the day, you can react immediately to any market news, good or bad. With a mutual fund, you’ll have to wait until the end of the day to execute any trades. Additionally, some mutual fund companies have short-term redemption fees if you trade more often than every 30 days or so.
ETFs might fit the bill if you’re a cost-conscious investor. Overall, ETFs carry lower expense ratios, on average. For example, the average equity mutual fund expense ratio at the end of 2016 was 0.63 percent, whereas the average equity ETF expense ratio was 0.23 percent. Some fund companies, however, including Vanguard mutual funds, do focus on low overall costs.
The largest index mutual fund in the country, the Vanguard 500 Index Fund, and it carries an expense ratio of 0.08 percent, whereas the iShares Core S&P 500 ETF comes in at 0.04 percent — the same as the Vanguard ETF tracking the S&P 500.
Mutual funds have the edge when it comes to making regular investments, especially in small amounts. Most mutual fund companies allow automated investment, sometimes in amounts as low as $50 or even lower, which can be a great way for beginners or regular investors to save. Monthly investments in a mutual fund typically help you avoid fees. In contrast, if you were to buy regular amounts of an ETF every month, you’d have to pay a separate transaction cost each time.
Tax-conscious investors might lean toward ETFs over mutual funds because mutual funds are required to make distributions of capital gains. Exchange-traded funds can often avoid paying capital gains due to the way that they are structured.