ETFs vs mutual funds

ETFs and mutual funds seem similar, but they have some key differences. Find out what they are.

Exchange-traded funds (ETFs) and mutual funds are both options you come across when deciding on your investments. On the face of it, they’re pretty similar with both being collections of investments (equities, bonds and alternative assets). They are a means for investors to pool their resources and gain access to a diversified portfolio of assets at relatively low cost.

However, there are important differences, such as the types of investments they hold, how they are bought and sold, and how suited they are to different investors.

What are ETFs?

An exchange-traded fund (ETF) is a bunch of investments all collected together. It tends to be a relatively cheap and liquid way to invest in a range of different assets. The most popular ETFs track major indices such as the S&P 500 or FTSE 100.

While the mutual fund market is still far larger, the ETF market has grown significantly in recent years. Across Europe, the ETF market now represents around one-third of all assets held and it continues to grow. ETFs also offer a means to hold a broad set of investments. There are ETFs based on currencies, commodities, volatility indices and sectors. It is also possible to have 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.

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What are mutual funds?

Mutual funds are “open-ended”. 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 mutual funds, there’s a fund manager, who, you guessed it, manages the fund by buying and selling assets. Mutual funds do not trade on an exchange: the shares are priced 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, a US 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 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.

In contrast, passively managed funds just try to replicate an index or the performance of an asset. You can get both passive and active ETFs.

The active versus passive choice has drawn many headlines. Those who prefer passive argue that most active managers don’t perform better than the index, so it’s not worth paying the extra fees. Those who support active argue that good fund managers can deliver performance well ahead of the index, more than justifying their fees.

Ultimately, it comes down to personal choice. Here are the key considerations:

  • Index funds tend to be cheaper. Costs are in the investor’s control, future returns are not.
  • Many active funds don’t add value over and above the index, but a good one can add a lot to your returns.
  • Index funds will tend to be concentrated in the largest stocks – expect HSBC, GSK, Shell or BP in the UK or Facebook, Apple, Amazon or Microsoft in the US. This is fine if it 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 can’t move out of companies that look like they’re heading into difficulties. As such, mutual funds can be a better choice in difficult markets.
  • Environmental, social and governance considerations – while there are ETFs that have an ESG tilt, active managers are generally in a better position to build these considerations into a portfolio.

Minimum investment levels

The minimum investment tends to be higher for mutual funds than ETFs. They tend to be £3,000 or more for mutual funds but as little as £50 for ETFs.

Expense ratios

In general, ETFs are cheap. It is possible to buy an S&P 500 ETF for 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.

The annual management fee can exert a significant drag on your investments over time. The difference between a £10,000 investment growing at 5% per year and 4.5% per year over 25 years is £34,813 versus £30,737. 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 normal share. 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 their 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.

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All investing should be regarded as longer term. The value of your investments can go up and down, and you may get back less than you invest. Past performance is no guarantee of future results. If you’re not sure which investments are right for you, please seek out a financial adviser. Capital at risk.

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