Mutual Funds vs. ETFs: Similarities and Differences

Exchange-traded funds, or ETFs, are versatile investment tools that offer broad market exposure at relatively low costs. They comprise a collection of securities, such as bonds, commodities, stocks, currencies, derivative products, and, more recently, Bitcoin futures. 

The SPDR S&P 500 ETF Trust (NYSE:SPY) was the first ETF launched stateside in 1993, which seeks to replicate the returns of the S&P 500 index.

The ETF manager (or sponsor institution) is responsible for the initial purchase of the holdings in a given exchange-traded fund.These holdings are pooled into an ETF under a unique ticker symbol, which then can be traded intraday retail investors, mostly through their brokerage accounts. 

However, the supply of ETF shares is different from that of company stocks. Common stocks have a fixed amount of shares outstanding. On the other hand, ETFs can change the supply of available shares to match demand. Thus, the fund’s price movements are driven mainly by the performance of its underlying securities rather than the supply/demand of the ETF. 

The Securities and Exchange Commission (SEC), which regulates ETFs,  provides details about these funds. Investors are encouraged to learn more about the suitability of ETFs for their portfolios. 

For more information about ETFs, see our dedicated guide: What is an ETF?

Mutual funds invest in a diverse portfolio of stocks, bonds, and other securities using the funds collected from a small group or individual investors. The SEC offers detailed information on mutual funds, including important points on investor protection.

As one of the oldest investment vehicles, the history of mutual funds in the US goes back to the 19th century. The 20th century witnessed an enormous growth in the number of mutual funds. In early 2022, there were over 7,500 mutual funds stateside.

Today, in terms of total assets, mutual funds still remain the most popular instrument, mainly thanks to retirement saving accounts, such as 401(k) plans. Metrics suggest around two-thirds of assets in 401(k)s are in mutual funds.  

Like ETFs, mutual funds are also professionally managed, and mostly offered through a broker. Expense ratios of mutual funds are usually identical to their ETF counterparts, but it’s a good idea to check out the best online brokers for ETF investing before leaping in.

In recent years, we have witnessed a trend whereby mutual funds are being converted into ETFs. Analysts suggest an increasing number of  investors now prefer ETFs over mutual funds. 

Among the reasons cited for these conversions are the intraday liquidity, more transparency, as well as potential tax benefits. This conversion trend has recently become more apparent in cases where a mutual fund and an ETF offer a similar product (such as two versions of the same asset class). Then, investors typically prefer the ETF version. Put another way, the growth in the number of ETFs is in part happening at the expense of mutual funds.

ETFs and mutual funds, especially open-end funds, have many similar attributes. Yet, a couple of notable differences could persuade an investor to choose one over the other. 

• Investment Pools

Both ETFs and mutual funds pool money from a large number of investments to provide access to an asset class or investment style. In other words, professional managers take the daily steps to research, analyze and trade the securities or assets in the fund. 

As a result, most retail investors find it relatively easy to understand the basics (such as asset class, investment style, expenses) of both ETFs and mutual funds. 

Yet, it might be disconcerting for some investors that they individually lack control over which holdings are in a given ETF or mutual fund. Therefore, investors need to do proper due diligence to appreciate whether a given ETF or mutual fund fits with their overall investment objective. 

• Asset classes

Both ETFs and mutual funds give access to different asset classes, such as equities, bonds, commodities or multi-assets—a fact that has made such funds extremely popular among investors.

However, especially in equities, ETF investors typically have access to a wider range of industries and subsectors.

ETF: No minimum initial investment amount; can be bought for the market price of a single share of an ETF.

Mutual Fund: Most of them require a minimum investment amount of between $500 to $5000.

ETF: Can be traded at the current market price intraday.

Mutual Fund: Open-end funds can only be executed after market close, at the final settlement price, the NAV. However, closed-end funds (CEFs) can be traded intraday.

ETF: Can be sold short; bought on margin; also allows for intraday trades, stop and limit orders. In addition, a large number of ETFs have options traded on them. Therefore, active traders utilize ETFs frequently as well.  

Mutual Fund: In open-end funds, investors can only add or remove capital, or invest/disinvest. Options are not traded on mutual funds, either.

ETF: Most are passively managed and pegged to a market index or sector sub-index returns.

In addition, there are inverse and leveraged ETFs or those that utilize option strategies (such as covered calls or buying puts).

Mutual Fund: Generally actively managed, with fund managers trading securities within the fund to outperform the market.

Most mutual funds are long only, meaning they buy and hold their assets as per their investment objectives. 

However, although few in number, there are also long/short, inverse and leveraged mutual funds. Some also use derivative products such as futures and options. 

ETF: Can have both implicit and explicit costs. For instance, in addition to the annual expense fee, there could be brokerage trading commissions. Each trade involves a bid/ask spread, and could be premium/discount to NAV.

In general, actively managed ETFs have higher operating costs than passive funds

Mutual Fund: In open-ended funds, there is no intraday trading and hence there are no trading commissions.

Aside from annual operating expenses, there may be transaction fees such as sales loads or redemption fees. Sales charges are typically called ‘loads.’ 

Front loads are paid at the time of the mutual fund purchase. Similarly, back loads become due at the time of the sale.

Actively managed mutual funds charge higher fees and higher expense ratios, reflecting the higher operating costs involved in active management.

On a final note, when investors compare a mutual fund with an ETF where both invest in the same asset class, then it is likely that the expense ratio for the mutual fund will be higher.  

Buying and selling securities, such as ETFs or mutual funds, leads to taxable consequences. Taxes for investments understandably depend on the jurisdiction and an investor’s background. Therefore, investors need to do further research on their individual circumstances. 

In the US, investment income is “interest, dividends, capital gains, and other types of distributions including mutual fund distributions.” As the Internal Revenue Service (IRS) could change the federal withholding tables at different intervals, tax obligations may differ from one year to the next.

Taxation of capital gains and dividends is typically similar for both ETFs and mutual funds. However, there are subtle differences, as well.

ETF: ETFs may offer tax advantages. ETFs trade on an exchange. When investors buy and sell ETFs, the ETF creator (sponsor) does not have to redeem shares. Thus, there could be less capital gains due to lower turnover and the in-kind creation/redemption process.

Mutual Fund: Taxation might be more complex and not necessarily favorable for the individual investors. Therefore, further due diligence is necessary.

For instance, a distribution takes place when a mutual fund company passes earnings to investors. Tax payers are responsible for reporting these distributions for which they should also pay taxes. Different funds are likely to have different policies for making distributions.

When mutual fund investors buy or sell shares, the fund manager needs to re-balance the fund, leading to a change in the portfolio. As a result, there could be taxable consequences for the remaining shareholders in the mutual fund.  

Additionally, the turnover rate of an actively-managed fund will be different to an index fund, resulting in different tax liabilities. 

ETF: Investors cannot make automatic investments or withdrawals into ETFs.

Mutual Fund: Investors can typically set up automatic investments and withdrawals, based on trading preferences, into and out of mutual funds.

ETF: ETFs generally disclose holdings online daily.

Mutual Fund: Mutual funds usually disclose holdings every quarter.

Diversification: 

ETFs and mutual funds both give access to a basket of securities that typically hold a wide range of stocks, bonds, or other investment assets. For instance, investors can choose from domestic as well as international equities and bonds. 

They also can invest in currencies, commodities and multi-assets through an ETF or mutual fund. Market participants can also focus on niche markets, such as a particular segment of technology stocks. There are also niche ETFs or mutual funds that enable traders to take leveraged or reverse positions in an asset class or index. 

As a result, investors can diversify their holdings which helps decrease portfolio volatility.

Accessibility/Simplicity: 

As investment vehicles, both ETFs and mutual funds are relatively easy to comprehend and include in portfolios. Ease of trading and relatively low costs make them accessible for most retail investors. 

Professional management: 

Investment companies  and trained industry professionals and typically launch and manage ETFs and mutual funds. Once an investor makes the purchase, then the asset manager takes over the research, analysis, trading and monitoring of the holdings in the ETF or the mutual fund. 

Lack of control: 

Because ETFs and mutual funds are managed by fund managers, investors have no control over the individual securities included in the portfolio. 

Portfolio rebalancing: 

Values of assets held in ETFs and mutual funds fluctuate as a result of changing market conditions. Therefore, after a certain period of time, an investment portfolio holding a number of ETFs or mutual funds may not necessarily reflect an investor’s investment objectives or risk tolerance.

Thus, individual investors should ideally review ETFs and mutual funds in their portfolios regularly. As a result, they may need to sell some of those funds and buy new ones instead. 

Market risk: 

Although ETFs and mutual funds usually reduce volatility through a diversified mix of investment securities, they cannot completely avoid all market risk, such as the loss of principal invested during market declines. Therefore, potential investors need to do due diligence before committing their capital into an ETF or mutual fund. Also, having a long-term horizon is important.