There are fundamental differences between mutual funds and ETFs that investors should know before choosing which will work better for their financial goals. Each fund type has its advantages and disadvantages. More importantly, mutual funds and ETFs can be used together to build a diversified portfolio.
- When you buy into a mutual fund, you pay the net asset value (NAV) of the stocks in the fund, but when you buy an ETF, you pay the market price.
- ETFs typically have lower expense ratios than most mutual funds, which can provide a slight edge in returns over index funds for the investor.
- Mutual funds can be either passively managed or actively managed, whereas most ETFs are passively managed.
- A portfolio of both mutual funds and ETFs can offer you more diversity and further reduce the risks that naturally come with investing.
What Are the Differences Between Mutual Funds and ETFs?
|Trading Time||Fund managers make trades after market hours||Bought at any time|
|Purchase Price||Purchased at net asset value||Bought at market price|
|Expenses||Higher expense ratios||Lower expense ratios|
|Management||Can be passively and actively managed||Are mostly passively managed|
|Automation||Can set up automated transactions||Cannot set up automatic transactions|
Timing and Pricing
You can buy a mutual fund at any time of the day, but the fund's managers cannot make trades within the fund until the end of the day. Exchange-traded funds (ETFs) can be traded throughout the day, so you might see your ETF value fluctuating while trading is going on.
The price at which you buy or sell a mutual fund isn't the price but the net asset value (NAV) of the stocks that make up the fund. When you invest in your mutual fund, your money is used for trading the fund's NAV at the end of the trading day. For example, it's common for mutual funds to have a minimum buy-in, like $3,000. So if shares cost $100, you are buying 30 shares.
When you buy an ETF, you're buying it at the current market price. You can buy one or as many shares as you can afford at the current price.
ETFs typically have lower expense ratios than most mutual funds. In theory, this can provide a slight edge in returns over index funds for the investor. For instance, the Vanguard S&P 500 ETF (VOO) has an expense ratio of .03%, while the mutual fund version, Admiral Shares (VFIAX), has expenses of .04%.
Both track the same index, but VOO has had better returns over the long run than VFIAX (when comparing the 10-year or longer returns).
Management and Automation
Mutual funds can be either passively managed or actively managed, whereas very few actively managed ETFs are offered. ETFs are generally passively managed, which makes them most similar to index mutual funds.
Most brokers don't allow you to set up automatic payments into an ETF because they trade differently.
Mutual funds generally allow you to set up automatic investing because you give them a dollar amount that buys a certain number of shares.
Which Is Right For You?
You should 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.
Both mutual funds and ETFs enable you to buy a basket of securities in one purchase. They both typically invest within a stated or implied objective, such as growth, value, or income. In addition, they will usually invest within a specific category of stocks or bonds, such as large-cap stocks, foreign stocks, or intermediate-term bonds.
You can use one of these types to achieve diversity in your portfolio. However, you can also use them both to complement each other. For example, some investors like to use ETFs for sector funds and mutual funds for actively managed choices.
Be sure that you have a full mix of stocks from different industries that match your risk tolerance and objectives.
ETFs based on indexes generally run cheaper, so you can buy into them if you're limited on capital. For example, the Vanguard S&P 500 ETF (VOO) price was about $380 in early June 2021, while the minimum for the mutual fund Admiral Shares (VFIAX) version of the same index is $3,000.
The Bottom Line
ETFs offer real-time pricing so that you can invest based on price changes, or you can use mutual funds with a set-and-forget, buy-and-hold strategy. You can also buy into an ETF designed to track an index and provide returns as a buy-and-hold strategy, as well.
You can achieve diversity using one or the other. A portfolio of both can offer you even more diversity and further reduce the risks that naturally come with investing. In addition, both mutual funds and ETFs offer different prices, expenses, and ways to make your money grow.