ETF vs. Mutual Fund: What’s the Difference?

ETF vs. Mutual Fund: An Overview

Americans have over $30 trillion invested in mutual and exchange-traded funds (ETFs) combined, making these two investment vehicles the cornerstone of many people’s financial planning.

ETFs and mutual funds work by pooling money from many investors to buy a mix of stocks, bonds, or other investments. This lets everyday investors own small pieces of hundreds or thousands of different investments, even with modest amounts of money. If you’re an investor, you get instant diversification without picking every stock, bond, or other security yourself.

But while these investment cousins share some DNA, they differ in important ways that can affect your bottom line. ETFs typically charge lower fees and offer more trading flexibility. Meanwhile, mutual fund fees have come down significantly in the last generation, and they are often near or at par with their ETF cousins in expense ratios, which count for the bulk of the fees they charge.

Mutual funds also tend to have more hands-on professional management and stronger regulatory protections. Understanding these differences is crucial for making smart investment choices that align with your financial goals.

Key Takeaways

• Exchange-traded funds (ETFs) trade like stocks throughout the market day, while mutual funds trade only once daily after the market closes.
• Index-tracking ETFs typically cost less to own than mutual funds because they require less active management and charge lower fees.
• ETFs often provide more tax advantages since investors only pay capital gains taxes when they sell their shares.
• Mutual funds offer benefits like professional active management and stronger oversight, though these features usually come with higher costs.
• Both investment types can help you diversify by owning hundreds or thousands of different stocks or bonds, even with a modest investment.

ETFs

As their name suggests, ETFs trade on exchanges just like stocks. Most try to mirror the ups and downs of specific indexes like the S&P 500 by assembling a portfolio that matches the index constituents. So, if you own shares, for example, in the SPDR S&P 500 ETF (SPY), a popular fund that tracks the S&P 500, when you see news that the index has gone up in the day’s trading, that means the value of your shares did, too.

Much of the value of ETFs is in passively managed index funds:

Passive management generally makes ETFs cheaper than mutual funds, with lower expenses than index-tracking mutual funds. Because buyers and sellers are doing business with one another, the managers have far less to do. The ETF providers want the price of their ETFs to align as closely as possible to the NAV of the index. To do this, they adjust the supply by creating new shares or redeeming old shares.

Note

ETFs are more tax-efficient, with investors generally only paying capital gains tax after they sell their shares. Meanwhile, buying or selling by mutual fund managers can trigger capital gains that are passed on to investors even when the investors haven’t sold their shares in the fund.

Mutual Funds

Mutual funds, managed by financial companies like Vanguard, T. Rowe Price, and BlackRock, work differently from ETFs. Unlike stocks or ETFs, which trade throughout the day, mutual fund trades happen once daily, after the market closes. The price you pay or receive is based on the fund’s net asset value (NAV)—an end-of-day snapshot of what all the investments in the fund are worth.

Many mutual funds have professional managers actively picking investments, trying to beat the market’s performance or shift fund assets to match the needs of those in target-date funds. This hands-on approach typically makes them more expensive than passive or index-tracking funds.

Some funds also charge additional fees—like early withdrawal penalties if you sell within three days of buying—so reading the fine print is essential. That said, mutual funds are generally meant for long-term investing, so withdrawals so soon shouldn’t be an issue for most.

The first mutual funds tracked indexes, but most now are actively managed. Actively managed funds incur higher costs for analysts, economic and industry research, company visits, and administration. However, most are actively managed because a majority of Americans with 401(k)s use target-date funds.

Target-Date Funds

Target-date funds offer a “set it and forget it” approach to investing, particularly popular in retirement accounts like 401(k)s. As you get closer to retirement, these funds automatically adjust their mix of stocks and bonds, becoming more conservative over time. For example, a fund labeled “Target Date 2050” would gradually shift from mostly stocks to more bonds as it approaches the year 2050.

Think of target-date funds as a self-driving car that automatically adjusts its speed and direction based on how close you are to your destination. When retirement is far away, the fund takes more risks to seek growth. As retirement approaches, it automatically becomes more cautious to help protect your savings.

Most target-date funds are mutual funds, but there are target-date ETFs.

Most investors who use target-date funds keep it simple—typically investing in just one fund that matches their expected retirement year. These funds are especially popular in workplace retirement plans, where they’re often the default investment choice for employees who don’t pick their own investments.

88%

Households own 88% of mutual fund assets.

Key Differences Between ETFs and Mutual Funds

ETFs and mutual funds are both popular investment tools offering diversified exposure to various asset classes. However, they differ in several key aspects, including costs, trading flexibility, tax efficiency, and management style.

ETFs

• Trading: Throughout the day

• Cost and fees: Lower expense ratios, brokerage fees

• Management style: Primarily passive

• Tax efficiency: More tax-efficient

• Minimum investment: Price of one share

Mutual Funds

• Trading: End of day (NAV-based)

• Cost and fees: Higher expense ratios, potential load fees

• Management style: Often active

• Tax efficiency: Less tax-efficient

• Minimum investment: Generally higher

• Trading: ETFs are traded on stock exchanges throughout the day, allowing real-time pricing. Meanwhile, mutual funds are traded once a day after the market closes, with orders executed at the fund’s NAV.
• Cost and fees: Generally, ETFs have lower expense ratios because of passive management and operational efficiencies. They also do not incur front-end or back-end load fees. Conversely, mutual funds often have higher expense ratios, especially actively managed funds. A low percentage of mutual funds still charge load fees (about 8% of them), and investors might also face redemption fees if they withdraw early.
• Management style: Most ETFs are passively managed, tracking a specific index to mirror its performance. However, mutual funds are more commonly actively managed, with fund managers typically having to shift assets in target-date funds or outperform benchmarks in others.
• Tax efficiency: Typically, ETFs are more tax-efficient because of their structure, allowing for in-kind creation and redemption processes, which minimize capital gains distributions to shareholders. Meanwhile, mutual funds tend to have higher tax implications, as buying or selling by the fund manager can trigger capital gains, which are passed on to investors.
• Minimum investment requirements: ETFs have no minimum investment beyond the price of one share or unit, making them accessible to a broader range of investors. Conversely, mutual funds often require a minimum initial investment. But this depends on the fund.

Important

In 2024, the U.S. Securities and Exchange Commission approved the first spot bitcoin ETFs listed on the NYSE Arca, Cboe BZX, and Nasdaq exchanges. 

Key Similarities Between ETFs and Mutual Funds

Nevertheless, ETFs and mutual funds share several similarities, particularly in their purpose and structure. Both are designed to provide diversified, professionally managed investments that align with specific investors’ goals. Some similarities include the following:

• Diversification: Both ETFs and mutual funds pool investors’ money to buy a diversified portfolio of assets, reducing individual asset risk.
• Professional management: Both types of funds are overseen by professional investment managers who handle asset selection, portfolio balancing, and rebalancing.
• Regulatory oversight: Both ETFs and mutual funds are regulated. In the U.S., these funds are overseen by the SEC and must adhere to specific legal and financial reporting standards.
• Liquidity: Both investment vehicles allow investors to liquidate their holdings relatively easily.
• Accessibility: ETFs and mutual funds offer relatively affordable access to a diversified portfolio compared with buying individual stocks or bonds.
• Variety of investment options: The two invest in equities, bonds, commodities, real estate, or a mix.

Since index-tracking funds are the most popular with investors, here’s a specific comparison of these types of ETFs and mutual funds.

When Does a Taxable Event Occur for an ETF?

For an all-ETF portfolio, the tax will generally only be an issue should investors sell their shares. Just like mutual funds, if an ETF pays dividends, these count as taxable income.

When Are Investors Liable for Gains Earned From a Mutual Fund?

Unless individuals invest through 401(k) or other tax-favored vehicles, mutual funds will distribute taxable gains to investors, even if they merely hold the shares.

What Is Meant By “Open-End” or “Closed-End” Fund?

Mutual funds and ETFs are both open-ended. The number of outstanding shares can be adjusted up or down in response to supply and demand. A closed-end fund sells a fixed number of shares once, though it might have follow-on offerings.

The Bottom Line

ETFs and mutual funds have proven to be durable and valuable tools for investors building a diversified investment portfolio. ETFs typically appeal to cost-conscious investors who want the flexibility to buy or sell when it suits them and appreciate ETFs’ tax efficiency. ETFs’ lower costs make them particularly attractive for long-term, hands-off investors comfortable with an index-following strategy.

Mutual funds, especially target-date funds, offer professional management and can be ideal for retirement savers who prefer a more structured approach. While they usually cost more, mutual funds provide features like automatic rebalancing. The choice between the two often comes down to your investment style, how actively you want to manage your portfolio, and your tax situation.