Mutual Fund vs. ETF: An Overview
Mutual funds and exchange-traded funds represent a popular way for investors to diversify but they have some key differences. While ETFs can be traded intra-day like stocks, mutual funds can only be purchased at the end of each trading day based on a calculated price known as the net asset value.
Mutual funds in their present form have been around for almost a century, with the first mutual fund launched in 1924. Exchange-traded funds are relatively new entrants in the investment arena, with the first ETF launched in January 1993: the SPDR S&P 500 ETF Trust (SPY).
Most mutual funds are actively managed, meaning fund managers made decisions about how to allocate assets in the fund. ETFs are usually passively managed, and track market indexes or specific sector indexes. However, that distinction has become blurred, as passive index funds make up a significant proportion of mutual funds' assets under management, while there is a growing range of actively managed ETFs available to investors.
Key Takeaways
- Mutual funds are usually actively managed, although passively-managed index funds have become more popular.
- ETFs are usually passively managed and track a market index or sector sub-index.
- ETFs can be bought and sold just like stocks, while mutual funds can only be purchased at the end of each trading day.
- Actively managed funds tend to have higher fees and higher expense ratios due to their higher operations and trading costs.
- An open-ended mutual fund has no limit to the number of shares, while a closed-ended fund has a fixed number of shares regardless of investor demand.
Mutual Funds
On average, mutual funds typically have a higher minimum investment requirement than ETFs. Although there are funds with no minimum investment, a typical retail fund requires a minimum investment of between $500 and $5,000.
Those minimums can vary depending on the type of fund and company. For example, the Vanguard 500 Index Investor Fund Admiral Shares requires a $3,000 minimum investment, while The Growth Fund of America offered by American Funds requires a $250 initial deposit.
Many mutual funds are actively managed by a fund manager or team, making decisions to buy and sell stocks or other securities within that fund to beat the market and help their investors profit. These funds usually come at a higher cost since they require substantially more time, effort, and manpower for securities research and analysis.
Mutual fund Purchases and sales occur directly between investors and the fund. The fund's price is not determined until the end of the business day when net asset value (NAV) is determined.
Types of Mutual Funds
There are two legal classifications for mutual funds: open-ended and closed-end. The distinctions between the different types lie in the fund shares.
Open-Ended Funds
These funds dominate the mutual fund marketplace in volume and assets under management. With open-ended funds, the purchase and sale of fund shares take place directly between investors and the fund company. There's no limit to the number of shares the fund can issue. So, as more investors buy into the fund, more shares are issued. Federal regulations require a daily valuation process, called marking to market, which subsequently adjusts the fund's per-share price to reflect changes in portfolio (asset) value. The value of an individual's shares is not affected by the number of shares outstanding.
Closed-End Funds
These funds issue only a specific number of shares and do not issue new shares as investor demand grows. Prices are not determined by the net asset value (NAV) of the fundbut are driven by investor demand. Purchases of shares are often made at a premium or discount to NAV.
It's important to factor in the different fee structures and tax implications of these two investment choices before deciding if and how they fit into your portfolio.
Exchange-Traded Funds (ETFs)
ETFs can cost far less for an entry position—as little as the cost of one share, plus fees or commissions. An ETF is created or redeemed in large lots by institutional investors and the shares trade throughout the day between investors like a stock. Like a stock, ETFs can be sold short. Those provisions are important to traders and speculators, but of little interest to long-term investors. But because ETFs are priced continuously by the market, there is the potential for trading to take place at a price other than the true NAV, which may introduce the opportunity for arbitrage.
ETFs offer tax advantages to investors. As passively managed portfolios, ETFs (and index funds) tend to realize fewer capital gains than actively managed mutual funds.
By the Numbers...
The United States is the world's largest market for mutual funds and ETFs, accounting for 48% of total worldwide assets of $60.1 trillion in regulated open-end funds as of the start of 2023. According to the Investment Company Institute, in 2022, U.S.-registered mutual funds had $22.1 trillion in assets, compared with $6.5 trillion in assets for U.S. ETFs. At year-end 2022, there were 8,763 mutual funds and 2,989 ETFs in the U.S.
ETF Creation and Redemption
The creation/redemption process of ETFs distinguishes them from other investment vehicles and provides a number of benefits. Creation involves buying all the underlying securities that constitute the ETF and bundling them into the ETF structure. Redemption involves "unbundling" the ETF back into its individual securities.
The ETF creation and redemption process occurs in the primary market between the ETF sponsor - the ETF issuer and fund manager that administers and markets the ETF - and authorized participants (APs), who are US-registered broker-dealers that have the right to create and redeem shares of an ETF. The APs assemble the securities included in the ETF in their correct weights and deliver those securities to the ETF sponsor.
For example, an S&P 500 ETF would require the APs to create ETF shares by assembling all the S&P 500 constituent stocks - based on their weights in the S&P 500 index - and delivering them to the ETF sponsor. The ETF sponsor then bundles these securities into the ETF wrapper and delivers the ETF shares to the APs. ETF share creation is generally in large increments, such as 50,000 shares. The new ETF shares are then listed on the secondary market, and trade on an exchange, just like stocks.
With an ETF redemption, the process is the opposite of ETF creation. APs aggregate ETF shares known as redemption units in the secondary market and deliver them to the ETF sponsor in exchange for the underlying securities of the ETF.
ETF Benefits
The unique ETF creation/redemption process results in ETF prices tracking their net asset value closely, since the APs monitor demand for an ETF closely and act promptly to reduce significant premiums or discounts to the ETF's NAV.
The creation/redemption process also means that the ETF's fund manager does not need to buy or sell the ETF's underlying securities except when the ETF portfolio has to be rebalanced. Since an ETF redemption is an "in kind" transaction as it involves ETF shares being exchanged for the underlying securities, it is typically tax-exempt and makes ETFs more tax efficient.
Thus, while the process of creating and redeeming shares of a mutual fund can trigger capital gains tax liabilities for all shareholders of the mutual fund, this is less likely to occur for ETF shareholders who are not trading shares. Note that the ETF shareholder is still on the hook for capital gains tax when the ETF shares are sold; however, the investor can choose the timing of such a sale.
ETFs may be more tax efficient than mutual funds because of the way they are created and redeemed.
Types of ETFs
There are three structures of ETFs:
- Exchange-Traded Open-End Fund: The vast majority of ETFs are registered under the SEC's Investment Company Act of 1940 as open-end management companies. This ETF structure has specific diversification requirements, as for example, no more than 5% of the portfolio can be invested in securities of a single stock. This structure also offers greater portfolio management flexibility compared to the Unit Investment Trust structure, as it is not required to fully replicate an index. Therefore, a number of open-end ETFs use optimization or sampling strategies to replicate an index and match its characteristics, rather than owning every single constituent security in the index. Open-end funds are also permitted to reinvest dividends in additional securities until distributions are made to shareholders. Securities lending is allowed and derivatives may be used in the fund.
- Exchange-Traded Unit Investment Trust (UIT). Exchange-traded UITs also are governed by the Investment Company Act of 1940, but these must attempt to fully replicate their specific indexes to limit tracking error, limit investments in a single issue to 25% or less, and set additional weighting limits for diversified and non-diversified funds. The first ETFs, such as the SPDR S&P 500 ETF, were structured as UITs. UITs do not automatically reinvest dividends but pay cash dividends quarterly. They are not allowed to engage in securities lending or hold derivatives. Some examples of this structure include the QQQQ and Dow DIAMONDS (DIA).
- Exchange-Traded Grantor Trust. This is the preferred structure for ETFs that invest in commodities. Such ETFs are structured as grantor trusts, which are registered under the Securities Act of 1933, but not registered under the Investment Company Act of 1940. This type of ETF bears a strong resemblance to a closed-ended fund, but an investor owns the underlying shares in the companies in which the ETF is invested. This includes having the voting rights associated with being a shareholder. The composition of the fund does not change, though. Dividends are not reinvested, but they are paid directly to shareholders. Investors must trade in 100-share lots. Holding company depository receipts (HOLDRs) is one example of this type of ETF.
Mutual Funds vs. ETFs
Mutual Funds
Can own a variety of different securities.
Shares are purchased and sold only with the fund provider.
Orders only settle after the market closes.
Minimum investment is usually a flat dollar amount.
May be active or passively managed.
May be less tax efficient because sales of securities within the fund can generate capital gains.
ETFs
Can own a variety of different securities.
Shares can be traded between investors.
Orders settle during market hours.
Minimum investment is typically equal to the price of one share.
Are usually passively managed.
May be more tax efficient.
Mutual funds and ETFs both offer investors the opportunity to get exposure to a large number of securities more easily, but it's important to understand precisely how they differ.
Both ETFs and mutual funds are managed by a fund manager who tries to achieve the stated investment goals of the fund. For example, an S&P 500 mutual fund or ETF typically tries to match the makeup and returns of the S&P 500 index. Investors can buy shares in the fund to get exposure to all of the securities that it holds.
In exchange for managing the fund, the fund managers charge a fee, called an expense ratio.
One of the most key differences between ETFs and mutual funds is in how they're traded.
With mutual funds, you buy and sell shares directly with the fund provider. Transactions also only occur after trading ends for the day and the fund's manager can calculate the value of a share in the fund.
ETFs, on the other hand, trade more like stocks. You can buy and sell shares in an ETF on the open market with other investors. It is also possible to buy or redeem shares with the fund provider, but that is less common. Because shares trade throughout the day rather than after the market closes, ETFs are a better choice for active traders.
Often, ETFs, are cheaper to invest in as well. Mutual funds often have minimum investment requirements of hundreds or thousands of dollars. You can invest in an ETF so long as you have enough money to buy a single share. Because ETFs are usually passively managed, while some mutual funds have more active management, ETF expense ratios are usually lower.
Mutual Fund vs. ETF Redemption Example
For example, suppose an investor redeems $50,000 from a traditional Standard & Poor's 500 Index (S&P 500) fund. To pay the investor, the fund must sell $50,000 worth of stock. If appreciated stocks are sold to free up the cash for the investor, the fund captures that capital gain, which is distributed to shareholders before year-end.
As a result, shareholders pay the taxes for the turnover within the fund. If an ETF shareholder wishes to redeem $50,000, the ETF doesn't sell any stock in the portfolio. Instead, it offers shareholders "in-kind redemptions," which limit the possibility of paying capital gains.
Is It Better to Invest in the Market Through a Mutual Fund or ETF?
The main difference between a mutual fund and an ETF is that the latter has intra-day liquidity. So if the ability to trade like a stock is an important consideration for you, the ETF may be the better choice.
Are ETFs Riskier Than Mutual Funds?
While ETFs and mutual funds that otherwise follow the same strategy or track the same index are constructed somewhat differently, there is no reason to believe that one is inherently more risky than the other. The riskiness of a fund depends largely on the underlying holdings, not the structure of the investment.
Do Index ETF vs. Mutual Fund Fees Differ Given the Same Passive Strategy?
The difference in fees today is marginal in many cases. For example, some of the biggest and most popular S&P 500 ETFs have anexpense ratioof 0.03%. Vanguard's S&P 500 ETF (VOO) has an expense ratio of 0.03%, while the Vanguard 500 Index Fund Admiral Shares (VFIAX) has an expense ratio of 0.04%.
Do ETFs Pay Dividends?
Yes, many ETFs will pay dividend distributions based on the dividend payments of the stocks that the fund holds.
Have Index Funds Become More Popular?
Index funds, which track the performance of a market index, can be formed as either mutual funds or ETFs. These funds have become more popular than actively managed funds because they have lower research and management costs, which can be passed on to the investor in the form of lower expense ratios. Total net assets in these two index fund categories had grown from 25% of all investment funds to about 50% between 2013 and 2023, according to research by the UCLA Anderson School of Management.
The Bottom Line
Mutual funds and exchange-traded funds are two popular ways for investors to diversify their portfolio, rather than betting on the success of individual companies. The main difference is that ETFs can be traded throughout the day, just like an ordinary stock. Mutual funds, on the other hand, can only be sold once a day, after the market closes.
