What's the Difference Between a Mutual Fund and an ETF?

Mutual funds and exchange-traded funds (ETFs) are very similar. Both are professionally managed collections of individual stocks, bonds, or other securities. When investors buy shares of an ETF or a mutual fund, they own a portion of the collection of assets rather than individual investments, which offers instant diversification at a minimal cost.

Diversification

Diversification is a strategy intended to lower the negative impact on your portfolio by investing in multiple holdings rather than just a few stocks, in multiple geographic regions, and multiple asset classes, such as bonds, and stocks. Both types of funds are comprised of a mix of many different investments and provide diversification benefits by default. By buying a share of a mutual fund or ETF, investors are adding hundreds or thousands of holdings just in one trade.

It is possible to build a well-diversified portfolio that covers all aspects of the U.S. and international stock and bond markets with just several mutual funds or ETFs.

What is an Index Fund?

Both mutual funds or ETFs can be index funds. Some will have the word "index" in their name. An index fund is a type of mutual fund or exchange-traded fund (ETF) with holdings that match a financial market index. A market index is a specific group of stocks, bonds, or other investment assets. A fund that mimics a market index, or in other words, a fund that is made up of the stocks or bonds from a specific list - is an index fund. An example of a market index is the energy sector of the U.S. and an example of an index fund is the Vanguard Energy Index Fund - a fund that tracks the energy sector of the U.S. equity market.

In the U.S., the most popular indices include the Standard & Poor's 500 Index (S&P 500), Nasdaq Composite, and Dow Jones. There is a number of mutual funds or ETFs that track these indices.

What is an Actively Managed Fund?

Active funds employ money managers who try to beat market returns by picking investments that they believe will do better. Active funds trade more often and cost more to run than index funds. The costs get passed on to the investors and the management expense ratios of actively managed funds are significantly higher than the expenses of index funds. This active buying and selling of stocks known as "turnover" also result in taxable capital gains, which decreases the tax efficiency of actively managed funds. Both mutual funds or ETFs can be actively managed funds, although actively managed ETFs are less common.

Differences Between Mutual Funds and ETFs

The main difference between mutual funds and ETFs is in how they are traded. Orders to either buy or sell mutual funds can be placed at any time but are executed at the end of the trading day. Everyone who buys or sells shares does so at the same price which is determined at the close of the stock market. As the name suggests, exchange-traded funds can be bought and sold on stock exchanges whenever the market is open, just like stocks. Just like stocks, ETFs have order types that give more control over the share price. Investors can place an order for ETF shares as a market order, limit order, and stop-loss order.

Other Key Differences

Minimum holding periods. Mutual funds usually have minimum holding periods and some trade restrictions. You may need to wait a specific number of days before you can sell the shares you bought in. ETFs don't have minimum holding periods.

Minimum initial investments. Mutual fund minimum initial investments are typically a flat dollar amount. You may be required to invest a few hundred or even a few thousand to add a mutual fund to your portfolio, although some brokers offer mutual funds with zero minimum initial investment.

There is usually no minimum required to start investing with ETFs. ETFs are sold at the price of one share and depending on the ETF, that price could be from $50 to a few hundred dollars. You can add an ETF to your portfolio by buying just one share or even a part of a share - many brokerages these days allow buying fractional shares.

Automatic investment plans. You can automate your mutual fund investments and withdrawals by setting up a transaction schedule and the amount you want to invest or withdraw. Some brokers offer recurring investments for ETFs, but in most cases, you can't set up automatic transactions into or out of ETFs.

Costs. ETFs generally have lower fees but the difference is usually marginal for similar holdings. For example, the expense ratio of Vanguard Total Stock Market ETF (VTI) is 0.03% and the expense ratio of Vanguard Total Stock Market Index Fund (VTSAX) is 0.04%.

Active vs. passive management. Index funds, also known as passively managed funds, are less costly. Most ETFs are index funds, therefore are often regarded as the cheaper fund type. But many passively managed mutual funds have similar expense ratios to ETFs.

Keep in mind that there are brokerage-specific differences. Some brokers can charge fees for trading mutual funds and ETFs. Some brokers may have annual fees and other expenses which may vary greatly from one brokerage firm to another. Many brokers do not charge any fees besides fund expense ratios for neither mutual funds nor ETFs.

Automatic rebalancing. There are mutual funds, called target date funds or life-cycle funds, that automatically change the asset allocation of your portfolio based on your age. These funds are designed to take more risks with the potential of greater reward when you're young and get more conservative over time. There are currently no target date ETFs in the market.

Tax efficiency. ETFs are often more tax efficient than mutual funds.

ETFs vs. Mutual Funds: Which is the Better Investment?

Mutual funds and ETFs essentially work the same and the long-term performance will depend on the fund's investments, its operating expense ratios, commissions, and other fees that you may incur. For example, mutual funds and ETFs based on the S&P 500 index will be similar in performance but the final value of your investment may be drastically different depending on the cost of trading and all other brokerage fees. Expense ratios and brokerage fees often affect your portfolio growth more than the type of the chosen fund and will eat into the returns no matter whether it is a mutual fund or an ETF.

Although ETFs have a slight edge over mutual funds in terms of tax efficiency and expense ratios, in some circumstances, passively managed mutual funds can be cheaper than ETFs, simpler to automate investments for long-term goals, and the tax implications are irrelevant if mutual funds are held in tax-advantaged accounts, such as 401(k) or IRA.

Mutual funds are typically better for long-term investing and passive investors may be happier to automatically invest in index funds which will help avoid the temptation to time the market. Or take an even more passive route and put investing on autopilot by regularly contributing to target-date funds, which automatically rebalance their assets based on investors' age.

The low fees and possibility of intraday trading of ETFs make them more practical for short-term goals. Hands-on investors may find ETFs more suitable for their investment strategy. And if it makes sense in your case, there is certainly nothing wrong with having both of these fund types in your portfolio.

Whether ETFs or mutual funds are the better investment for you, like any other investment choice, depends on your financial situation. Before making any trades, you should always consult a financial professional.