What’s the difference between ETFs and mutual funds? (2024)

Exchange-traded funds (ETFs) and mutual funds are two popular ways investors can own diversified investments in a single vehicle.

Mutual funds have been around for 100 years and, for decades, people have used them to invest alongside skilled, active portfolio managers. About 30 years ago, ETFs debuted as a way for individual investors to easily access passive indexes.

When comparing ETFs versus mutual funds, investors will quickly learn these investment vehicles have many similarities and differences. Understanding those nuances will help investors determine whether they want to choose mutual funds versus ETFs, or both, for their portfolios.

How ETFs and mutual funds are similar

ETFs and mutual funds often try to accomplish similar goals, says James Sahagian, managing director of Ramapo Wealth Advisors at Steward Partners. Both allow investors to pool assets together to benefit from professional investment management and diversified holdings in a single fund.

Both types of funds can be actively managed, meaning portfolio managers are picking securities based on their research, or passively managed, meaning they are index-following funds that seek to mirror the performance of a specific benchmark. Many mutual funds are actively managed, with some following an index. Most ETFs are passively managed, but actively managed ETFs are becoming popular, says Steven Naiser, senior portfolio manager at Bartlett Wealth Management.

Comparing ETFs and mutual funds investment strategies

Strategy-wise, there’s little difference between index mutual funds and index ETFs since they both allow investors to buy stocks, bonds, real-estate investment trusts, commodities or other types of investments. ETFs and mutual funds are “40-Act” funds, which is short for the Investment Company Act of 1940, an investor protection act. Under the act, fund companies must alert investors to the risks of buying and owning funds.

What is a mutual fund and how does it work?

A mutual fund is an investment company that pools money from investors to purchase securities, which are then managed by professional portfolio managers.

When investors buy mutual fund shares, the portfolio manager buys securities in the market, and the fund pays the commissions and costs to trade. Mutual funds trade once at the day’s end. They are priced at the net asset value (NAV), which is the value of all the underlying investments divided by the number of units outstanding.

Mutual funds are only required to disclose holdings each quarter and with a 30-day lag, so investors only get a snapshot of what they own. Some disclose monthly.

Sometimes mutual fund portfolio managers will shutter the vehicle to new investors if they feel the assets under management are too big to effectively handle, Sahagian says. That’s especially true with small-cap funds where investment ideas can be limited and the fund’s size can influence market conditions.

What is an ETF and how does it work?

An ETF is another type of pooled investment that trades on stock exchanges and typically tracks index funds or other asset classes, although some ETFs are actively managed.

The creation and redemption mechanism behind ETFs is why they are typically cheaper, more transparent and tax efficient than mutual funds. ETF issuers use authorized participants, entities that can create and redeem ETF shares, to create a basket of securities that the ETF will hold, such as all the underlying securities in the Dow Jones Industrial Average.

The authorized participant delivers those securities to the ETF issuer, and the fund issuer gives the authorized participant a set of ETF shares that equal the value of the delivered securities. This is the creation unit, and the authorized participant can sell those shares on an exchange. To redeem shares, the authorized participant purchases those ETF shares and delivers them to the ETF issuer, and the authorized participant receives the same value in underlying securities.

This process allows ETFs to trade during the day and keep the share prices close to the fund’s underlying NAV. Since the authorized participant does almost all the buying and selling, that entity pays those costs, not the fund. New investors pay the costs through the bid and ask spread when they buy and sell ETFs.

Since ETF issuers and authorized participants aren’t taking on new investors, just expanding or contracting the pool based on creations and redemptions, they can create more assets based on money flows and don’t have to worry about closing the fund to new investors.

ETF issuers publish daily lists of what securities the authorized participants need to deliver to create or redeem shares. Actively managed ETFs are required each day to fully disclose their portfolios.

Cost comparison of ETFs versus mutual funds

Aside from potential commission costs charged by brokerage firms, ETFs have one type of fee —the annual expense ratio. Mutual funds have an annual cost, but may also have 12b-1 fees, which are advice and assistance costs embedded into the expense ratio, and may have an initial sales load, which typically ranges between 4% and 8% and paid upfront. Sales loads are the commission paid to the broker who is selling the fund. Some mutual funds do not have load fees, so look closely at the total costs before buying a mutual fund, Naiser says.

Mutual fund annual expense fees are higher, too. The Investment Company Institute says the average expense ratio for equity mutual funds was 0.44% in 2022, which means an investor would pay $4.40 annually on every $1,000 invested. The average expense ratio for bond mutual funds was 0.37%. Mutual fund investors can save money by choosing index funds over active funds. The average cost for an actively managed equity mutual fund was 0.66% while an index-based mutual fund’s average annual fee was 0.05%.

The Investment Company Institute says the average annual expense ratio for index equity ETFs was 0.16% in 2022, while the average index bond ETF fee was 0.11%.

Tax considerations and liquidity issues for ETF and mutual fund investors

When mutual fund investors want to sell their shares, the portfolio manager must sell securities to raise cash if they don’t have enough money on hand.

Mutual fund portfolio managers’ liquidity needs can sometimes hamstring them during market dislocations, such as during the pandemic’s initial market crunch, when many investors panicked and sold holdings, Sahagian says.

“It really puts mutual fund managers at a disadvantage, because when they have big redemptions in a short period of time, not only are they forced to sell at a time when they probably wouldn’t want to, but they also have to maintain a certain amount of cash liquidity available to meet the redemptions,” he says.

Portfolio managers may need to sell long-held securities they originally bought cheaper to raise that cash, triggering a capital gain. Because all investors’ money is pooled together, even new investors inherit the embedded cost basis of when the portfolio manager first bought those shares. It’s also why sometimes mutual fund investors receive capital gains tax bills even if the fund has lost money during the year, Naiser says.

When ETF investors sell their shares at a profit, they sell to other investors, so the fund doesn’t incur capital gains, only the investor. It’s why ETF funds don’t suffer the same liquidity issues as mutual funds.

When an authorized participant wants to redeem shares with an issuer, the issuer hands back the underlying holdings to the authorized participants. This “in-kind” redemption doesn’t create any capital gains, Naiser says, which is why ETFs are typically more tax efficient. Both investment vehicles pass through dividends and interest that are taxable to the investor, he adds.

Minimum investment requirements for ETFs versus mutual funds

The minimum investment requirements for mutual funds vary, with some as low as zero, but can range from $2,500 to $10,000 or more. ETFs have no set required minimums in order to invest. The minimum cost to invest is the price of one share of the ETF.

“ETFs definitely have become much more popular with investors, because they typically have lower costs, lower fees, and they offer more flexibility in terms of getting in and out when you need to,” Sahagian says.