The difference between ETFs and mutual funds

ETFs are more tax efficient, and investors can buy just one share.

  • By Ellen Chang,
  • U.S. News & World Report
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Exchange-traded funds and mutual funds resemble each other and share many of the same qualities as they give investors the ability to diversify with low-cost options in their retirement portfolios. The differences in how these two types of funds are traded can affect the yield and capital gains in a retirement portfolio. Since exchange-traded funds are baskets of individual stocks, investors can add a specific sector to a portfolio.

To compare exchange-traded funds versus mutual funds, here are some key aspects to consider:

  • ETFs charge lower fees.
  • ETFs are easier to trade.
  • Mutual funds are actively managed.

ETFs charge lower fees

Investors can see the underlying holdings of index funds since they are more transparent investing vehicles. The majority of index funds aim to mirror a benchmark such as the S&P 500 (.SPX) or the Nasdaq (.IXIC), says Mike Loewengart, managing director of investment strategy at E-Trade Financial, an Arlington, Virginia-based brokerage company.

Since many ETFs track an index, the expense ratios are often very low. For example, Vanguard's S&P 500 ETF expense ratio is 0.03%. Those costs can make a big difference for long-term investors.

Another consideration is that ETFs are traded on an exchange, which means you can buy and sell them throughout the day. They do not require a minimum amount, and novice investors can start by adding even one share of an ETF to an individual retirement account.

"While mutual funds and ETFs are sliced and diced in a myriad of ways, understanding the basics is critical before jumping in," Loewengart says. "ETFs can be a low-cost way to build a diversified portfolio."

ETFs are easier to trade

ETFs mimic stocks and investors can conduct different order types such as stop orders, limit orders and short selling, says Stuart Michelson, a finance professor at Stetson University.

Individuals who trade in and out of an ETF often need to consider the bid-ask spread of the ETF since that is a transaction cost they are paying but may not realize, says Derek Horstmeyer, assistant professor of finance at George Mason University in Fairfax, Virginia. ETFs are more tax efficient than mutual funds given their in-kind redemptions.

"This usually can net someone who is investing in an equity ETF an extra 30 basis points or 0.30% a year as compared to the same mutual fund," he says.

Since ETFs are bought and sold throughout the trading day and are often focused on narrow market niches, many investors use them to implement their short-term views or to express long-term views, says Jodie Gunzberg, managing director and chief institutional investment strategist at New York-based Morgan Stanley Wealth Management.

"ETFs have grown in popularity from their strong performance in the last decade with easy monetary policy, higher correlation and tighter dispersion, but as that changes, active managers may outperform, shifting the flows towards mutual funds, especially if the desired active strategies are unavailable in ETFs," she says.

Mutual funds are actively managed

Mutual funds typically have an experienced fund manager that delivers "competitive risk-adjusted performance by taking positions that reflect their conviction about the economic environment and valuations," Gunzberg says. Mutual funds are popular in tax-free retirement accounts like an IRA or 401(k) plan since no capital gains are generated.

The majority of mutual funds are actively managed, and most ETFs track an index, although the "lines have been blurring in recent years," says Todd Rosenbluth, head of ETF and mutual fund research at CFRA, a New York financial research company.

Mutual funds tend to be more expensive and are more likely to underperform an index or fail to repeat the success of its performance in consecutive periods, he says.

"This is why people are increasingly choosing ETFs over mutual funds," Rosenbluth says. "An advantage for mutual funds is that you can easily dollar-cost average to build a position over time and avoid trying to time the market."

One advantage of ETFs is that investors can intraday trade them and they are "less likely to incur capital gains taxes if they continue to hold the fund, unlike with a mutual fund," he says.

A drawback is that mutual funds can only be purchased at the end of each trading day based on a calculated price, but automatic investments and withdrawals are generally easier with these funds, Michelson says. Mutual funds typically come with a higher minimum investment requirement than index funds. Purchases and sales of mutual funds take place directly between investors and the fund, while ETFs are purchased and sold on the market.

"Mutual funds and ETFs are less risky than investing in individual stocks and bonds because of diversification," he says. "Both offer a wide variety of investments, including broad indexes and individual sectors," he says.

Since mutual funds aim to beat the market, the fund's holdings are "kept behind closed doors for longer," Loewengart says. "Investors have to do some homework on the portfolio manager's track record and fund investment objectives."

Investors are paying for the expertise of the fund manager in an attempt to beat their benchmark, so the fees tend to be higher with mutual funds.

"While there are a few key differences, they're both solid ways to gain access to a group of stocks, which takes some of the heavy lifting out of stock selection and mutual funds can help investors unlock value in more opaque areas of the market," he says. "But at the end of the day, when weighing which way to go, it comes down to your risk tolerance, goals and time horizon."

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