Mutual Funds vs. ETFs
Know the similarities and Differences before investing
There are fundamental differences between mutual funds and ETFs that investors need to know before choosing which is best for their financial goals. Each fund type has its advantages and disadvantages. Perhaps most importantly, and if used correctly, mutual funds and ETFs can be used together to build a diversified portfolio.
Similarities of Mutual Funds and ETFs
Investors considering the purchase of any type of fund may also seek out information on the differences between mutual funds and exchange-traded funds (ETFs). But before going over the differences between the two fund types, there are a few key similarities that are valuable to know.
Here's how mutual funds and ETFs are alike:
- Mutual funds and ETFs are diversified investments: Both mutual funds and ETFs enable investors to buy a basket of securities within one investment security. They both typically invest within a stated or implied objective, such as growth, value, or income, and they will usually invest within a certain category of stocks or bonds, such as large-cap stocks, foreign stocks, or intermediate-term bonds.
- ETFs are similar to index mutual funds: ETFs are passively-managed, which makes them most similar to index mutual funds. Within this similarity, both the index fund and the ETF will mirror the performance of an underlying index, such as the S&P 500; they both have extremely low expense ratios compared to actively-managed funds, and they both can be prudent investment types for diversification and portfolio construction.
Differences Between Mutual Funds and ETFs
There are several differences between mutual funds and ETFs that are important to know before choosing which is best for your investment objective.
Here are the key differences between mutual funds and ETFs:
- Mutual fund vs. ETF timing of trade settlement: Mutual funds trade at the end of the day, while ETFs trade intra-day. For example, let's say you want to buy or sell a mutual fund. The price at which you buy or sell isn't really a price; it's the Net Asset Value, or NAV, of the underlying securities; and you will trade at the fund's NAV at end of the trading day. In contrast, ETFs trade intra-day like stocks. This can be an advantage if you are able to take advantage of price movements that occur during the day. On some days the market can move higher or lower by as much as 1% or more. This presents both risk and opportunity, depending upon your accuracy in predicting the trend.
- Ability to make stock orders with ETFs: Another distinction ETFs have in relation to their stock-like trading aspect is the ability to place stock orders (or market orders), which can help overcome some of the behavioral and pricing risks of day trading. For example, with a limit order, the investor can choose a price at which a trade is executed. With a stop order, the investor can choose a price below the current price and prevent a loss below that chosen price. Investors do not have this type of flexible control with mutual funds.
- Spreads on ETFs: Part of the trade-able aspect of ETFs is what is called the "spread," which is the difference between the bid and ask price of a security. However, to put it simply, the biggest risk here is with some ETFs that are not widely traded, where spreads can be wider and not favorable for individual investors. Therefore look for broadly traded index ETFs, such as SPDR S&P 500 (SPY) or iShares Core S&P 500 Index (IVV), and beware of niche areas such as narrowly traded sector funds and country funds.
- Mutual fund vs. ETF expenses: ETFs typically have lower expense ratios than most mutual funds and can sometimes have expenses lower than index mutual funds. This can, in theory, provide a slight edge in returns over index funds for the investor. However, ETFs can have higher trading costs. For example, some brokerage firms charge commissions for trading ETFs. If you trade ETFs frequently, the cost of the commissions could end up exceeding the savings on the lower expense ratio compared to the comparable mutual fund.
- Active vs. passive management: Mutual funds can be either passively-managed or actively-managed; whereas there are very few actively-managed ETFs offered today.
The Bottom Line
Should you use mutual funds or ETFs? The index funds vs. ETF debate need not be an either/or question. If an investor is comparing an index mutual fund and an ETF that both track the same benchmark index, the fund with the lowest expense ratio is generally the smart choice.
But for building a diversified portfolio, mutual funds and ETFs can be complementary to each other. For example, some investors like to use ETFs for sector funds and mutual funds for actively-managed choices. Either way you decide, just be sure the mix is diversified and is suitable for your risk tolerance and investment objectives.
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.