ETFs and mutual funds are simply structures or vehicles that facilitate access to underlying investments. Enthusiasts refer to exchange-traded funds (ETFs) as modernized mutual funds—even calling them mutual funds 2.0. Meanwhile, detractors cite the shortfalls of ETFs and tout mutual funds as king. Cutting through the confusion is really just a matter of understanding the differences, and understanding where each structure makes the most sense.
Let's review the fundamental difference between the two structures. To keep things simple, we'll focus exclusively on index-based funds and ETFs.
On one level, both mutual funds and ETFs do the same thing.
Let's imagine, for instance, two products that are designed to track the S&P 500: an ETF and a mutual fund. If you look under the hood, both products will hold all (or most) of the 500 stocks in the index, in the exact proportion in which they exist in the index. At this point, the two product structures are identical.
The difference of course is that ETFs are "exchange traded." That means you can buy and sell them intraday, like any other stock. By contrast, you can only buy or sell index funds once per day, after the close of trading. You do this by contacting the mutual fund company directly and telling them you want to acquire or redeem shares.
What does all that mean for investors? And how do you choose? Let's examine the differences.
The positives of ETFs
- Intraday Liquidity: Those fancy words mean you can buy and sell ETFs at any time during the trading day. If the market is falling apart, you can get out at 10 a.m. In a mutual fund, you would have to wait until after the close of trading … which could be a costly delay.
- Lower costs: Although it's not guaranteed, ETFs often have lower total expense ratios than competing mutual funds. The reason is simple: when you buy shares of a mutual fund directly from the mutual fund company that company must handle a great deal of paperwork to record who you are, where you live, and to send you documents. When you buy shares of an ETF, you do so through your brokerage account, and all the record-keeping is done (and paid for) by your brokerage firm. Less paperwork equals lower costs. Most of the time.
- Transparency: Holdings in an ETF are disclosed on a regular, frequent basis, so investors know what they are investing in and where their money is parked. Mutual funds, by contrast, are only required to disclose their holdings quarterly, with a 30-day lag.
- Tax Efficiency: ETFs are almost always more tax efficient than mutual funds because of how they interact. See our article "ETFs vs. Mutual Funds: Tax Efficiency"
- Greater flexibility: Because ETFs are traded like stocks, you can do things with them you can't do with mutual funds, including writing options against them, shorting them and buying them on margin.
The cons of ETFs
- Commissions: The beauty of intraday liquidity does not come without costs. Typically, you pay a commission when you buy or sell any security, and ETFs are no different. If you regularly invest a small amount of money in an ETF—for example, $200 per paycheck—those commissions can be cost-prohibitive. There are an increasing number of commission-free ETF trading programs in place, including Fidelity. But check before you trade.
- Spreads: In addition to commissions, investors also pay the "spread" when buying or selling ETFs. The spread is the difference between the price you pay to acquire a security and the price at which you can sell it. The larger the spread—and for some ETFs, the spread can be quite large—the larger the cost. There is no way to get around this.
- Premiums and Discounts: When you buy or sell a mutual fund at the end of the day, you always transact exactly at its stated "net asset value" (NAV), so you always get a "fair" price. While mechanisms exist that keep ETF share prices in line with their fair value, those mechanisms are not perfect. At any given moment, an ETF might trade at a premium or a discount to its NAV. If you buy at a premium and sell at a discount, ouch … you've lost out.
- General Illiquidity: While exchange-trading sounds great, not all ETFs are as tradable as you think. Some trade rarely, or only at wide spreads. These become the financial equivalent of the Hotel California: You can never leave.
Neither mutual funds nor ETFs are perfect. Both can offer comprehensive exposure at minimal costs, and can be good tools for investors.
For most, the choice comes down to what you value most: Do you value the absolute lowest expense ratio and the flexibility of trading intraday? Go with ETFs. Do you worry about the impact of commissions, premiums, spreads and other factors? Go with mutual funds. Others look at taxes, reserving the ultra-tax-efficient ETFs for taxable accounts and using mutual funds in tax-deferred accounts.
Importantly, there is no reason this must be an either/or question. Mutual funds can live side by side with ETFs in a portfolio perfectly happily.
Exchange-traded products (ETPs) are subject to market volatility and the risks of their underlying securities, which may include the risks associated with investing in smaller companies, foreign securities, commodities, and fixed income investments. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks, all of which are magnified in emerging markets. ETPs that target a small universe of securities, such as a specific region or market sector, are generally subject to greater market volatility, as well as to the specific risks associated with that sector, region, or other focus. ETPs that use derivatives, leverage, or complex investment strategies are subject to additional risks. The return of an index ETP is usually different from that of the index it tracks because of fees, expenses, and tracking error. An ETP may trade at a premium or discount to its net asset value (NAV) (or indicative value in the case of exchange-traded notes). The degree of liquidity can vary significantly from one ETP to another and losses may be magnified if no liquid market exists for the ETP's shares when attempting to sell them. Each ETP has a unique risk profile, detailed in its prospectus, offering circular, or similar material, which should be considered carefully when making investment decisions.