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ETFs vs mutual funds: Which are right for you?
ETFs and mutual funds seem similar, but they have some key differences. Find out what they are.
However, there are important differences, such as the types of investments they make, how they are bought and sold, and how suited they are to the needs of different investors.
What are ETFs?
An exchange-traded fund (ETF) is a collection of assets sold as one. The most popular ETFs track major indexes such as the S&P 500 or FTSE 100; buying a share gives you a piece of every stock in that index. These days you can find ETFs tracking nearly every form of investment. They are a relatively cheap and liquid way to invest in just about any asset or strategy.
While the mutual fund market is still far larger, the ETF market has grown significantly in recent years. The U.S. ETF market surpassed $5 trillion in value in 2020. There are ETFs based on currencies, commodities, volatility indices and sectors. There are inverse ETFs that allow an investor to benefit from falling prices, and leveraged ETFs that give investors greater exposure to an individual asset or index (and with that, greater exposure to risk.)
ETFs trade on exchanges, like stocks, with prices fluctuating throughout the market day.
What are mutual funds?
Mutual funds are “open-ended” funds. This means that changes can be made to the fund at any time, as opposed to “closed-ended” funds, where the pool of capital remains the same. For a mutual fund, there’s a fund manager, who, you guessed it, manages the fund by buying and selling assets. Managers have benchmarks and targets to meet or exceed, and stated strategies for investors to study. Knowing the benchmarks and the manager’s record is key when picking a mutual fund.
Mutual funds do not trade on an exchange: the shares are priced once daily, based on their current net asset value.
ETFs vs mutual funds: Key similarities
Selection of assets. Both ETFs and mutual funds blend a variety of different assets and are a popular way to achieve a diversified portfolio at low cost.
Less risk. Both are less risky than investing in individual stocks and bonds.
Similar investment mix. In many cases, the mix of investments will be the same, for example, an S&P 500-based mutual fund and an S&P 500 ETF may hold many of the same stocks.
Wide variety of investment options. With both, you can invest in stocks, bonds, currencies and commodities.
ETFs vs mutual funds: Key differences
While the two have plenty of similarities, ETFs and mutual funds have some key differences that change the way you invest in them. These are:
Active vs passive
Actively managed funds are ones that have a real person behind them picking the shares that the fund is invested in based on whether they think the value will rise or not. Typically, mutual funds are actively managed; some are committed to following strict benchmarks like matching an index’s performance, while others give managers free rein.
In contrast, passively managed funds just try to replicate an index or the match performance of an asset. You can buy actively managed ETFs these days, but passive ETFs are still much more common.
The active versus passive choice has drawn many headlines. Those who prefer passive argue that most active managers don’t perform better than indexes, so it’s not worth paying the extra fees that pay their salaries. Those who support active management argue that good fund managers can deliver performance well ahead of an index, more than justifying their fees.
Ultimately, it comes down to personal choice. Here are the key considerations:
- Passively managed funds, particularly index funds, tend to be cheaper. Costs are in the investor’s control; future returns never are.
- While many active funds don’t add value over and above an index or benchmark, the good ones can add a lot to your returns. That’s why some fund managers become famous.
- The largest index funds tend to be concentrated in the largest stocks – expect Facebook, Apple, Amazon or Microsoft in the large-cap US indexes, for example. This is fine if this is the right investment mix for an investor’s age and stage, but some will want greater exposure to faster-growing parts of the market or more “safety.”
- Index funds have to hold every stock in an index. They can’t move out of companies that look like they’re heading into difficulties. As such, mutual funds with sharp managers can be a better choice in difficult markets.
- Environmental, social and governance considerations might also come into play. While there are ETFs that have an ESG tilt, active managers are generally in a better position to build these considerations into a portfolio that still generates strong returns.
Minimum investment levels
The minimum investment tends to be higher for mutual funds than ETFs. While a few mutual funds require no minimums, they generally range from $1,000 on up. You can generally buy ETFs for the cost of a share, which could be $50 or less.
In general, ETFs are cheap. It is possible to find an S&P 500 ETF with an expense ratio under 0.1%. This will be higher for niche areas, such as emerging markets, and also for more complex ETFs, such as those with leverage.
Actively managed funds, in contrast, are more expensive, with expense ratios between 0.5% and 0.75%. This is because an investor is paying for an experienced fund manager and their research team to uncover stocks they believe will rise. They also tend to trade more often.
The annual management fee can exert a significant drag on your investments over time. That said, a good fund manager can deliver many multiples of their fees. As such, if an investor finds a good one, it can be well worth the extra cost.
Buying and selling
ETFs are traded on the stock market like a company stock. They can be bought or sold at any time during trading hours. You pay a brokerage fee for buying and selling, plus an ongoing annual management fee. For the largest and most liquid ETFs, this is usually around 0.1%, but may be higher for more specialist options. There will also be a “bid” price (the price to sell the ETF) and an “ask” price (the price to buy the ETF). In large ETFs, this will be minimal, but there can be a wider gap for smaller funds.
For mutual funds, you buy and sell through an investment platform. You pay an annual management fee, usually between 0.5% and 0.75% depending on the fund and its approach. When the holding is sold, it may take three or four days and, if the market moves in the interim, the price may be notably different.
ETFs vs mutual funds: Which should I choose?
ETFs are likely to be the right choice if:
- You want to move in and out of your investments quickly
- You want low cost access to a market
- You don’t have a lot to invest
- You want fully transparent pricing
- You want access to certain asset classes, including commodities or currencies
- You want short or leveraged access to specific asset classes
Mutual funds are likely to be the right choice if:
- You want a professional to oversee your investment
- You want a chance to do better than the index
- You don’t want to be concentrated in certain sectors
- You are saving regularly (month to month)
- You want access to specific asset classes such as property or private equity, which are difficult to achieve in ETF form
ETFs vs mutual funds: Summary
There are great ETFs and great mutual funds and the right choice will be highly personal. There will be times in the market when one does better over the other. Equally, the right option may be a blend of the two. There are strong views on both sides, but there is no right or wrong answer.
Compare trading platforms
To trade funds you’ll need the right brokerage account. ETF trading is much more common than mutual fund trading, so look at those rules carefully.
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