ETFs vs. Mutual Funds: What Should You Invest In?

Exchange-traded funds (ETFs) and mutual funds are investment vehicles that make it easy to diversify your investments. Both combine a bundle of assets into a convenient package and may follow either passive or active investment strategies. 

However, they have a few key differences you should consider before committing your hard-earned dollars. 

In this post, we’ll explore what ETFs and mutual funds are, their key differences, and how to choose between them and invest.

ETFs and mutual funds defined

One of the key challenges for individual investors is choosing and building a well-balanced, diversified portfolio. With so many options to choose from, and so little time to explore them in a rapidly changing market, it can be tough to stay on top of it. 

ETFs and mutual funds provide access to professionally managed and diversified investment pools without having to buy and rebalance a portfolio on your own. 

ETF definition

An exchange-traded fund (ETF) issues shares — tradeable on an exchange — representing a group of underlying assets. This allows investors to buy, sell, and short ETFs in their brokerage accounts, similar to stocks. ETFs are typically professionally managed and follow a stated investment mandate.

Mutual fund definition

A mutual fund pools money from investors to purchase a basket of securities like stocks, bonds, and/or commodities. Professional fund managers select investments according to the mutual fund mandate. 

Each fund issues shares to investors representing a tiny slice of the underlying investments, and investors can buy or redeem their shares with the fund issuer.  

ETFs vs. mutual funds — key differences

ETFs and mutual funds share many similarities – and a whole host of differences. Here’s what to know. 

Fund management

Both ETFs and mutual funds choose a benchmark index like the S&P 500 or Bloomberg US Aggregate Bond index to compare performance against. The chosen benchmark depends on the fund’s investment strategy and objectives. 

Most ETFs tend to be passively managed, which means they’re designed to match the performance of their benchmark index. By contrast, most mutual funds are actively managed, with fund managers trying to beat their benchmark.

In both cases, active funds cost more than passive funds. Between higher expense ratios and the difficulty of repeatedly outperforming the market, active funds may post lower long-term returns than passive funds. Under tough trading conditions in 2022, only 43% of 3,000 active funds tracked by Morningstar outperformed their average passive peer. 

Issuers can also create actively managed ETFs and passive mutual funds.

Pricing and Trading 

Since ETFs trade like stocks, they can be bought and sold during regular market hours. Pricing is subject to supply and demand and can fluctuate constantly. As a result, ETFs can trade at a premium or discount to their net asset value (NAV), which is the fair value of the underlying portfolio. 

There are no restrictions against short selling ETFs, so you can sell the ETF without owning it first to bet on its decline.

Mutual funds are more unusual in that they only trade once daily after the market closes. Additionally, all shares trade at the same NAV on a given day. In that sense, investors receive fair pricing based on the underlying assets held. Mutual funds cannot be sold short.

Taxes on gains

ETFs are relatively tax-efficient investments. Their structure and lower asset turnover allow them to minimize their investors’ capital gains tax burden. Generally, that means investors don’t pay taxes until they sell shares at a profit. 

Unfortunately, mutual funds don’t often share the same tax efficiency. When a mutual fund sells its underlying securities to accommodate investment flows, the fund often needs to distribute capital gains to its investors. That means you might pay taxes on your shares even if you still own them. 

Minimum investment requirements

ETFs don’t require a minimum investment — you just have to pay the market price. Since many brokerages permit fractional (partial share) ETF trades, you can start investing for as little as $1 (or your brokerage investment minimum). 

However, mutual funds often set minimum initial investment requirements. This flat dollar amount may range from $250 to over $5,000 depending on the fund. After your first purchase, most funds permit both fractional and dollar-based investing.  

One-time and ongoing fees

Both ETFs and mutual funds charge fees that are calculated as expense ratios. The ratio is a percentage of assets under management. For instance, a 0.25% expense ratio means $25 in fees for every $10,000 invested. However, the size of this fee varies dramatically.

Typically, passive ETFs charge the lowest ratios – anywhere from 0.03% to 0.25%. Actively-managed ETFs cost more and can be more than 1%. 

Since most mutual funds are actively managed, they typically charge anywhere from 0.50% to 1% (or more). Mutual funds may also charge other one-time and ongoing fees, including purchase fees, redemption fees, and management fees. 

Holdings reporting

Most passive ETFs report their holdings daily so investors can see what they own. A few (mostly active) ETFs report holdings changes on a monthly basis.  

By contrast, mutual funds typically report their holdings monthly to quarterly. As an investor, that means you may have to wait a few weeks to know exactly what you own.   

Investment strategies: Which one is right for you?

Both ETFs and mutual funds allow you to diversify your portfolio, track or outperform market indexes, focus on specific sectors, and access professional fund management without high balance requirements. However, they may not be ideal for all investment strategies. 

Before diving into either one, here are a few main factors to consider:  

• Capital gains tax events. Mutual funds tend to trigger capital gains taxes more frequently than ETFs. If you hold your shares in a tax-advantaged retirement account, the impact may be negligible. But if you’re investing in taxable brokerage accounts, ETFs may be a friendlier option. 
•  Minimum investment requirements. Most mutual funds require an upfront investment of $250 or more. If you can’t front the cash, you might have to stick with ETFs.  
•  Liquidity. Since ETFs permit intraday and after-market trades, you can make trades any time the markets are open. But with mutual funds, you’ll have to wait until market close to trade — or find out the value of your shares.  
• Fees. Overall, mutual funds tend to charge higher expense ratios and more fees. However, passive and no-load (no fee) mutual funds are becoming more common, and it’s best to check the specific fund fees.
• Your investment objectives. ETFs and mutual funds follow stated investment objectives, offering choices that may closely align with your goals or investment style. For example, ETFs or mutual funds may focus on “themes” like healthcare or technology to offer sector-based investing.  

Of course, you don’t have to limit yourself to just ETFs or mutual funds. If you find that both fit your investment strategy, you can try both!

How to invest in an ETF or mutual fund

Thanks to the internet, investing in your future is easier than ever — no matter your fund preferences.  

1. Research potential brokers. If you don’t already have a brokerage and/or retirement account, you’ll want to consider each broker’s:

• Commissions and fees
• Reputation
•  Product availability
•  Account minimums 

Additionally, if you’re investing in mutual funds, it’s important to know whether a broker offers the fund you want. Remember: most brokers primarily sell shares in the mutual funds they issue!

2. Open your account. Next, you’ll follow your chosen broker’s directions for opening an account. You’ll likely have to provide personal information like your name, address, and Social Security Number. In some cases, you may have to wait for the brokerage to approve your account before moving on.
3. Fund your account. Once your account is open, you’ll need to link your bank account to fund your purchases. This process is generally straightforward, but, again, may require verification from your broker and/or bank.  
4. Select and purchase your fund(s). The next step is to select the investments you’d like to add to your portfolio. Most brokers offer an intuitive platform to help you research available ETFs or mutual funds to fit your objectives. Evaluate trading fees before you place an order, which you can initiate by choosing the dollar amount or number of shares you’d like to purchase.  
5. Adjust your portfolio as necessary. It’s important to keep an eye on your investments — but not too close of an eye. Investing is a balancing act between keeping your assets in line with your long-term plans without making emotional decisions based on major market moves.

With some practice and a little research, you’ll be on your way to choosing an ETF or mutual fund that meets your goals in no time!