ETF Vs. Mutual Fund: Which Is Right For You? | Bankrate (2024)

Mutual funds and exchange-traded funds (ETF) can both offer many benefits for your investment portfolio, including instant diversification at a low cost. But they have some key differences, in particular, how expensive the funds are. Overall, ETFs hold an edge because they tend to use passive investing more often and have some tax advantages.

Here’s what differentiates a mutual fund from an ETF, and which is better for your portfolio.

Mutual funds vs. ETFs: Similarities and differences

Mutual funds remain top dog in terms of total assets, thanks to their prominence in retirement plans such as 401(k)s. U.S. mutual funds had around $22.1 trillion in net assets, at the end of 2022, compared to $6.5 trillion in ETFs, according to the Investment Company Institute. But ETFs have been growing quickly in the last decade, as investors are drawn by their low fees and ease of trading.

Both types of funds allow you to invest in a diversified portfolio by buying just one security. For example, you can buy an index fund based on (S&P 500) of top American companies as either a mutual fund or an ETF. Or you could buy a portfolio of bonds with either. Some funds allow you to buy gold or all the companies in a certain industry, for example.

Mutual funds: An overview

Mutual funds are an older way of allowing a group of investors to own a share in a larger portfolio. Mutual funds tend to be actively managed, so they’re trying to beat their benchmark, and may charge higher expenses than ETFs, including the possibility of sales commissions. Mutual funds typically have minimum initial purchase requirements, and they can be purchased only after the market is closed, when their net asset value (NAV) is calculated and set.

ETFs: An overview

ETFs are a newer way of allowing investors to own a share in a larger portfolio. ETFs tend to be passively managed, meaning their holdings track a preset index of securities rather than having a portfolio manager picking them. They generally charge low expenses and have no sales commissions. ETFs usually do not have a minimum initial purchase requirement, though some brokers may not allow you to buy fractional shares of them. ETFs are traded during the day like a stock and their price can fluctuate around their net asset value.

Whether you’re buying a mutual fund or an ETF, you can invest in a diverse selection of assets.

FeatureMutual fundsETFs
Type of assetsStocks, bonds, gold, etc.Stocks, bonds, gold, etc.
Type of fund managementMore actively investedMore passively invested
Fund expense ratiosHigherLower
Brokerage commissionsOften $0, but may range up to $50Typically $0
Sales commissions (loads)Often none, but sometimes 1 or 2 percentNone
When you can tradePriced at the end of the trading dayCan be purchased throughout the trading day
Tax efficiencyLowerHigher

Active management vs. passive management

How a fund actually invests has a lot to do with your costs and potential returns. Some funds engage in what’s called active management, in which the fund’s manager picks and chooses securities to buy and sell, and when to do so. This approach is more typical for mutual funds.

The other approach is called passive investing, and it’s where the fund manager doesn’t select the investments but rather mimics an index that’s already been selected, such as the S&P 500. This approach is more typical of ETFs, though ETFs may sometimes be actively managed.

So generally speaking, mutual funds have been actively managed, whereas ETFs have been passive. But these lines have blurred somewhat and it’s possible to find actively managed ETFs and passively managed mutual funds.

This difference matters for a couple key reasons: the returns you’re likely to see as an investor and the expense ratio you’re likely to pay.

Fund returns and costs

Here’s the upshot of the active vs. passive debate: passive investing does better most of the time. In fact, a recent report from S&P Dow Jones Indices shows that 90 percent of U.S. active managers in large companies were unable to beat the market over a 20-year period ending Dec. 31, 2021.

Yes, the best funds can beat their benchmarks (often the S&P 500) in a given year, but over time it’s tough for active managers to outperform.

In passive investing the goal is not to beat the market, as is usual for active managers. Instead, passive investors are simply looking to be the market. And if passive investing outperforms the vast majority of investors, it also means you can beat most active professional managers.

That gives an advantage to ETFs, which are typically passively managed, though again some mutual funds are also passively managed. You’ll need to read the fund’s prospectus to see.

Active management has another downside: it tends to cost more than a passively managed fund. The emergence of lower-cost ETFs has helped reduce the expenses in mutual funds.

As you can see in the chart below, expense ratios on funds have been falling for the past two decades. Expenses for stock mutual funds still remain above those for ETFs, whether you’re comparing a simple average or an asset-weighted average (factoring in how big the fund is).

The simple average gives you an idea of what you’d likely pay if you picked funds at random, while the asset-weighted average tells you what a typical investor might actually be paying. So mutual funds are quite a bit more expensive than ETFs, comparing their respective averages.

For example, in 2022 an average mutual fund (asset-weighted) would cost 0.44 percent of your assets each year. In practical terms, it would cost $44 for every $10,000 you have invested. In contrast, the comparable average ETF has an expense ratio of just 0.16 percent, or $16 annually for every $10,000 invested.

But the details differ when you dig in. If you focus on passively managed stock mutual funds, they’re actually cheaper than passively managed stock ETFs, as you can see in the chart below.

So in 2022, stock index mutual funds charged an average of 0.05 percent (asset-weighted), while a comparable stock index ETF charged 0.16 percent.

An actively managed mutual fund may also ding your returns in another way, by running up your tax bill. Because it trades in and out of the market, an actively managed fund recognizes capital gains more frequently than a passively managed fund such as most ETFs. It must pass on some of those taxable capital gains distributions to investors at the end of the year.

In addition to these costs, investors in mutual funds may also have to watch out for sales commissions, too, which can quickly eat up your principal before you’ve even invested your money. That’s not a cost that’s associated with ETFs – or the best mutual funds, for that matter.

Whether you go with an ETF or mutual fund, be sure to check the expense ratio and any other costs of the fund. Costs are a huge driver of your return, and experts suggest that you focus on those first, especially for index funds, where everyone is tracking the same index anyway.

Commissions and minimum purchases

In the category of commissions, ETF investors are real winners. The big-name brokerages have slashed commissions to zero on all ETFs offered on their site. So it won’t cost you anything to trade these funds, though some brokers may impose an early redemption fee. That’s a huge boon for investors, especially if you like to dollar-cost average on your purchases.

But that’s not the case for mutual funds, where some still charge sales commissions that might run you one or two percent of your money but sometimes even more. Fortunately, many good mutual funds no longer charge these fees, and it’s relatively easy to avoid them. Otherwise, you’re paying to enrich the fund-management firm at the expense of your returns.

And brokerages may also charge you a fee for trading mutual funds – some may run nearly $50 per trade – though the best brokers offer many funds without a trading commission.

As for a minimum purchase amount, ETFs often have an advantage here, too. Usually a broker may require you to buy at least one share of a fund in order to make a purchase, though these days many brokerages allow you to buy fractional shares. Even if you have to buy a full share, that might cost you as little as $20 up to perhaps $250, still a relatively small amount.

In contrast, some mutual funds may require you to purchase at least $2,500 to get started, if you’re opening your own individual account, with smaller minimum subsequent deposits. Some mutual funds also charge early redemption fees if you sell your position in less than 30 days.

When you can buy mutual funds and ETFs

The time and frequency when you can purchase a mutual fund or ETF differs. Mutual funds are priced only at the end of each trading day. While you can place your order at any time, it won’t be filled until the exact price of the fund is tallied up at day’s end. So you won’t know what you’re paying until the transaction is complete. But you’ll always pay the exact net asset value of the fund’s holdings.

In contrast, an ETF trades like a stock on an exchange, and you can buy whenever the market is open. You can place your buy or sell order as you would for a stock and see the exact price you pay when the order is executed. Unlike a mutual fund, you may end up paying more or less than the fund’s actual net assets, though the difference is usually negligible.

This trading flexibility has helped make ETFs a popular way to invest.

ETF vs. mutual fund: Which one should you choose and why?

In many ways mutual funds and ETFs do the same thing, so the better long-term choice depends a lot on what the fund is actually invested in (the types of stocks and bonds, for example). For instance, mutual funds and ETFs based on the are largely going to perform the same for you. But actively managed funds may have widely different results, depending on how they’re invested.

Where the differences come in, however, are in the fees, commissions and other costs associated with your choice. And in these respects, ETFs have an edge on mutual funds. They also have an edge in terms of their tax efficiency, helping to reduce your overall tax burden.

Do ETFs and mutual funds pay distributions?

Mutual funds may pay capital gains distributions at the end of the year and dividends throughout the year, while ETFs may pay dividends throughout the year. But there’s a difference in these payouts to investors, and ETF investors have an advantage here, too.

ETFs may pay a cash dividend on a quarterly basis. Each share will receive a specific amount, so the more shares you own, the higher your total payout. But not all funds offer dividends, even if they do provide a cash payout. For example, fixed income ETFs technically pay out interest instead.

ETF distributions can be either qualified or non-qualified. The difference between the two depends on how they are taxed and how long the stock within the ETF is held:

  • Qualified dividends are paid on stock held by the ETF. The stock must be owned for more than 60 days during a 121-day period that begins 60 days before the ex-dividend date. Qualified dividends are taxed at the capital gains tax rate.
  • Non-qualified dividends are taxed at ordinary income rates.

Mutual funds may also issue a payout, and it may be paid regularly throughout the year. Investors may also be able to take advantage of the rules surrounding qualified dividends to achieve a lower tax rate on payouts.

But mutual funds may also expose investors to an additional tax complication. That’s because mutual funds are required to distribute their realized capital gains at the end of the year. While you receive the payout in cash, you may then have to turn around and pay taxes on it to the IRS. These tax considerations don’t apply to mutual funds held in tax-advantaged accounts.

Even if the mutual fund isn’t trading a bunch of stocks as part of its strategy, the act of redeeming shares for outgoing investors can force managers to sell shares of the investments in the fund, potentially creating a capital gain.

Additionally, if you buy the fund late in the year, you could still be paying a tax bill for events that happened before you made the investment.

Mutual fund vs. ETF: Which one is safer?

In terms of safety, neither the mutual fund nor the ETF is safer than the other due to its structure. Safety is determined by what the fund itself owns. Stocks are usually riskier than bonds, and corporate bonds come with somewhat more risk than U.S. government bonds. But higher risk (especially if it’s diversified) may deliver higher long-term returns.

That’s why it’s critical that you understand the characteristics of your investments, and not just whether the fund is an ETF or mutual fund. A mutual fund or ETF tracking the same index will deliver about the same returns, so you’re not exposed to more risk one way or the other.

Bottom line

For many different purposes, an ETF is a better option for investors because it offers some tax advantages, low commissions and easy tradability. But in other specific circ*mstances, notably for stock index funds, mutual funds can actually be cheaper than ETFs, and if they’re held in a tax-advantaged account, their tax implications are irrelevant anyway. Either way, you need to know what your funds are invested in and how they help you achieve your financial goals.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.

ETF Vs. Mutual Fund: Which Is Right For You? | Bankrate (2024)


ETF Vs. Mutual Fund: Which Is Right For You? | Bankrate? ›

In many ways mutual funds and ETFs do the same thing, so the better long-term choice depends a lot on what the fund is actually invested in (the types of stocks and bonds, for example). For instance, mutual funds and ETFs based on the S&P 500 index are largely going to perform the same for you.

Should you invest in ETF or mutual funds? ›

Key takeaways. Both ETFs and mutual funds are popular investment choices. ETF investments usually have lower fees than mutual funds, however mutual fund investors get professional fund management services for their fees. Whether you decide to invest in ETFs or mutual funds may depend on the type of investor you are.

Should I switch from mutual fund to ETF? ›

If you're paying fees for a fund with a high expense ratio or paying too much in taxes each year because of undesired capital gains distributions, switching to ETFs is likely the right choice. If your current investment is in an indexed mutual fund, you can usually find an ETF that accomplishes the same thing.

What is the downside of ETFs? ›

For instance, some ETFs may come with fees, others might stray from the value of the underlying asset, ETFs are not always optimized for taxes, and of course — like any investment — ETFs also come with risk.

Should I invest in individual stocks or ETFs? ›

ETFs offer advantages over stocks in two situations. First, when the return from stocks in the sector has a narrow dispersion around the mean, an ETF might be the best choice. Second, if you are unable to gain an advantage through knowledge of the company, an ETF is your best choice.

Why would someone choose an ETF over a mutual fund? ›

ETFs and index mutual funds tend to be generally more tax efficient than actively managed funds. And, in general, ETFs tend to be more tax efficient than index mutual funds. You want niche exposure. Specific ETFs focused on particular industries or commodities can give you exposure to market niches.

Why would you choose ETFs over mutual funds? ›

ETFs offer numerous advantages including diversification, liquidity, and lower expenses compared to many mutual funds. They can also help minimize capital gains taxes. But these benefits can be offset by some downsides that include potentially lower returns with higher intraday volatility.

Why are mutual funds safer than ETFs? ›

In terms of safety, neither the mutual fund nor the ETF is safer than the other due to its structure. Safety is determined by what the fund itself owns. Stocks are usually riskier than bonds, and corporate bonds come with somewhat more risk than U.S. government bonds.

Should I get out of mutual funds now? ›

However, if you have noticed significantly poor performance over the last two or more years, it may be time to cut your losses and move on. To help your decision, compare the fund's performance to a suitable benchmark or to similar funds. Exceptionally poor comparative performance should be a signal to sell the fund.

When should I get out of mutual funds? ›

When it comes to equity, it is very important that, especially when you are thinking about long-term goals, you want to exit as soon as you have 2-3 years left approaching your goal and there are just 2-3 years to get there. That is number one.

Why I don't invest in ETFs? ›

Low Liquidity

If an ETF is thinly traded, there can be problems getting out of the investment, depending on the size of your position relative to the average trading volume. The biggest sign of an illiquid investment is large spreads between the bid and the ask.

Has an ETF ever gone to zero? ›

Leveraged ETF prices tend to decay over time, and triple leverage will tend to decay at a faster rate than 2x leverage. As a result, they can tend toward zero.

What happens if an ETF goes bust? ›

Liquidation of ETFs is strictly regulated; when an ETF closes, any remaining shareholders will receive a payout based on what they had invested in the ETF. Receiving an ETF payout can be a taxable event.

Are ETFs safer than mutual funds? ›

Both types of funds offer instant diversification and professional management of fund assets. They both involve less risk (and greater convenience) than investing in individual securities. ETFs are a newer option for investors and they were originally known for having far lower fees than comparable mutual funds.

Should I put all my money in one ETF? ›

Investing in an ETF that tracks a financial services index gives you ownership in a basket of financial stocks versus a single financial company. As the old cliché goes, you do not want to put all your eggs into one basket. An ETF can guard against volatility (up to a point) if some stocks within the ETF fall.

Are ETFs or mutual funds riskier? ›

In general, ETFs can be more risky than mutual funds because they are traded on stock exchanges. Their value can fluctuate throughout the day in response to market conditions. This means that if the market takes a dip, the value of your ETF could drop quickly, and you could experience significant losses.

Why are ETFs so much cheaper than mutual funds? ›

The administrative costs of managing ETFs are commonly lower than those for mutual funds. ETFs keep their administrative and operational expenses down through market-based trading. Because ETFs are bought and sold on the open market, the sale of shares from one investor to another does not affect the fund.

Do you pay taxes on ETF if you don't sell? ›

At least once a year, funds must pass on any net gains they've realized. As a fund shareholder, you could be on the hook for taxes on gains even if you haven't sold any of your shares.

Are ETFs more cost efficient than mutual funds? ›

ETFs expense ratios generally are lower than mutual funds, particularly when compared to actively managed mutual funds that invest a good deal in research to find the best investments.

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