The Difference Between ETFs and Mutual Funds

Investors today are met with a vast array of choices when it comes to their portfolios. With so many investment options, it can be difficult to differentiate one from the other. Mutual Funds and Exchange Traded Funds – or ETFs – are two investment types that seem similar on the surface but have important differences all investors should understand.

Let’s start with the ways in which Mutual Funds and ETFs are similar. First, they are both pooled fund investment options, meaning they consist of a collection of individual holdings which offer increased diversification for the investor’s portfolio. This also allows fund managers to save on transaction costs through economies of scale. Both usually invest within certain categories of holdings, such as large-cap stocks, emerging or foreign markets, or short-term bonds. Additionally, the two are largely regulated the same. At first glance they seem almost identical, but key differences exist.

One fundamental difference is the way ETFs and mutual funds are traded. ETFs, as the name would suggest, are traded on an exchange just like a common stock. This means they can be bought and sold anytime throughout the day. Some investors prefer this freedom as it allows them to try to time market highs and lows throughout the day, although for most investors this is not a factor due to the long-term nature of their investment plans. Conversely, mutual funds can only be bought and sold at market close. Any orders placed are settled at the price of the fund at day’s end. ETFs are bought and sold directly with other investors through an exchange, whereas your investment in a mutual fund is held with the company that runs the fund, such as BlackRock or Vanguard.

ETFs are usually passively managed, meaning the securities are automatically selected to match a part of the market or an index such as the S&P 500. On the other hand, mutual funds – though sometimes passively managed – are often preferred for their actively managed options. This means fund managers analyze and select securities aimed at outperforming an index or offering less overall risk. Actively managed funds tend to carry higher fees, which is one reason why ETFs have lower expense ratios on average.

Mutual funds are offered with multiple share classes. Share classes denote different expense ratios and minimum initial investment requirements. Individual investors generally invest in share classes that offer a lower minimum initial investment option, but with that often comes higher expenses. Wealth managers and other financial professionals may have agreements with the funds which allow more favorable investment options. On the contrary, the trading of ETFs is an investor-to-investor transaction, therefore share classes are not offered.

Another important difference between mutual funds and ETFs lies in potential tax implications. Like any investment, gains on mutual funds and ETFs are taxed via either short-term or long-term capital gains taxes. However, mutual funds pose an additional risk in the form of embedded capital gains. When purchasing shares of a mutual fund, you are taking on the embedded capital gains of that fund. This means the gains for individual securities within the fund are calculated based on the cost at the time the fund first purchased it, even if that was long before you invested. If the security is sold for a large gain, it could disproportionately affect your capital gains. This does not apply to ETFs, since gains are calculated based on the cost at the time you purchase a share. You don’t have to worry about embedded gains if investing through a retirement account such as a 401(k) or IRA, but it can be an important consideration if you’re investing through a taxable account.

As with much of investing, one option isn’t always better than another. Your investment goals may be better served by mutual funds, ETFs, or a mixture of both. The important thing is to understand the differences so you can make the best possible choice for your individual situation.