The Difference Between ETFs and Open-Ended Mutual Funds
There are several ways to buy into investments in the stock market without buying individual stocks or bonds. Exchange-traded funds (ETFs) and mutual funds are two of the most common ways to do this. Both of these options work well for this type of investing, and many investors use both. But there are some important differences to keep in mind.
The comparison and contrast here only applies to open-ended mutual funds (the type most investors are used to). In practice closed-ended funds function much more like ETFs.
Similarities Between ETFs and Mutual Funds
An exchange-traded fund is much like a regular mutual fund in that when you buy a share of an exchange-traded fund each share represents a tiny slice of all of the funds' underlying investments, allowing you to diversify across a pre-determined set of stocks or bonds by owning one single fund.
Most exchange-traded funds function like an index fund. For example, let's say you buy an S&P 500 Index ETF; that fund will own all 500 stocks listed in the S&P 500 index. It will not trade in and out of those stocks—it simply owns the stocks listed in the index. By buying a share of the fund, your money is instantly diversified across all of the underlying stocks.
However, exchange-traded funds differ from regular mutual funds in the way they are priced and in the way they trade, which means you can apply certain trading strategies with an ETF that you cannot with a regular mutual fund.
Pricing Mutual Funds and ETFs
A regular mutual fund sets its price once each day after the market has closed. The actual price at which you trade is unknown because orders are placed during or before a market close and then "filled" at the closest new market value. The closing value will be repriced based on the number of shares bought and sold and the net asset value of the total fund.
An exchange-traded fund price functions just like a stock, with fluctuations to the penny throughout the trading period. Since ETF funds price throughout the day, you can purchase or sell them mid-day, buy on a dip in the market, or sell on a rally. Because the stock market prices are influenced by current news and worldwide opinions, the prices are prone to sudden and frequent impulse changes.
One advantage ETFs have over regular mutual funds is typically a lower operating expense fee which means you are paying less to own the fund. Because the investor is actively involved in trading ETFs, most of them are passively managed, which means there are fewer management fees. You will, however, still pay commissions.
Trading Mutual Funds and ETFs
When you buy or sell shares of a regular mutual fund you buy or sell them directly to and from the investment company that issues them, so you cannot trade them mid-day, nor can you use trading strategies such as limit orders or market orders. You will buy shares of mutual funds in dollars, which means you may end up with an odd number of shares, including fractions. When you sell a mutual fund, it will be in shares, not dollars.
An exchange-traded fund, however, trades like a stock, pricing throughout the day. When you buy or sell it, you are trading it with other investors who are buying or selling. Since an ETF trades in this way, you can use trading strategies such as limit orders or stop losses, which allow you to specify a specific price or threshold at which you wish a transaction to occur. Because ETFs trade like stocks, you will always buy or sell in shares, not dollars.
Are ETFs Good for Retirement?
Although mutual funds are a common choice for retirement investing, fewer investors are familiar with using ETFs for this purpose. If you are building a portfolio of index funds, the exchange-traded version of the fund will be just fine.
ETFs can also be used to target specific sectors of the market or particular industries to which you want more exposure. However, for your retirement investing, stay away from leveraged ETFs, which attempt to perform at a rate of two to four times the comparable index fund. These funds can cause quick gains or catastrophic losses, all in a short period of time—not the ideal for a retirement fund.
The Bottom Line
Exchange-traded funds and mutual funds can both be great choices for retirement or other investing purposes. The best choice for you will largely come down to how active you want to be in stock trading and how much you think is reasonable to pay your fund managers to oversee your portfolio. Talk with an investment advisor for more information to help you decide between the two.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.