Exchange-Traded Funds vs. Mutual Funds

By Jane Young, CFP, EA

There are many similarities between exchange-traded funds (ETFs) and mutual funds. They both provide a vehicle to simplify investing and reduce risk, by pooling individual securities in a single fund which is professionally managed. You do not have to select individual securities to build your investment portfolio. ETFs and mutual funds provide a diversified portfolio without buying hundreds of individual securities. The funds can offer a wide variety of assets in various markets, industry sectors, regions, and asset classes. 

One significant difference between ETFs and mutual funds is how they are traded. ETFs trade like stocks, the market price of the ETF changes throughout the day and the price depends on when you buy or sell shares. The price may be less than the Net Asset Value (NAV) for less actively traded ETFs. Mutual fund trades are executed at the end of the day, after the major U.S. exchanges have closed. The price represents the NAV at the end of the day and is the same for all investors who placed a trade during the day. 

Mutual funds are bought and sold directly from mutual fund companies or brokerage firms that sell the fund. ETFs are traded on stock exchanges. Similar to individual stocks, with ETFs you can utilize advanced trading techniques including buying on margin, and placing limit or stop-loss orders.  ETFs are generally traded as whole shares and do not have minimums.  Mutual funds are usually traded as a fixed dollar amount and commonly have a minimum initial investment.

Most ETFs are passively managed where the holdings and performance are pegged to an index. Mutual funds are available as active and passive funds. In active funds the securities are selected by a fund manager with the intention of beating the benchmark index. ETFs usually have a slightly lower expense ratio and are more tax efficient. They generally have less turnover and lower trading costs.

ETFs provide more control over tax liability. Capital gains on securities sold within an ETF are not recognized until you sell the ETF. The ability to control when capital gains are recognized makes ETFs especially beneficial in non-retirement accounts where taxes on capital gains must be reported and paid every year.

With mutual funds the investor incurs a tax liability at the time a security is sold at a gain, within the fund. An investor must pay taxes on gains from trades made within the fund, even though the fund was not sold and even if the fund reports a loss for the year.

Mutual funds are usually a better choice for systematic investments because you can purchase a set dollar amount at regular intervals (dollar cost averaging). They may also be beneficial in tax advantaged accounts such as IRAs and 401k plans. Mutual funds have historically been your best option for actively traded funds. However, the range of options available in ETFs is expanding every day.