Exchange-traded funds (ETFs) and mutual funds are simply structures or vehicles that facilitate access to underlying investments. Enthusiasts refer to 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 differences between the 2 structures.
On one level, both mutual funds and ETFs do the same thing.
Let's imagine, for instance, 2 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 2 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 only 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? Let's take a closer look at ETFs.
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, for a simple reason: when you buy shares of a mutual fund directly from the mutual fund company, that company must handle a great deal of paperwork—recording who you are and where you live—and sending you documents. When you buy shares of an ETF, you do so through your brokerage account, and all the recordkeeping 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 and frequent basis, so investors know what they are investing in and where their money is parked. Mutual funds, by contrast, are required to disclose their holdings only quarterly, with a 30-day lag.
- Tax efficiency: ETFs are almost always more tax efficient than mutual funds because of how they interact. For more details, see 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 ones with 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 at 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 might 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.
The choice comes down to what you value most. If you prefer having the absolute lowest expense ratio and the flexibility of trading intraday, go with ETFs. If you worry about the impact of commissions, premiums, spreads, and other factors, go with mutual funds. If taxes are your priority, reserve the ultra-tax-efficient ETFs for taxable accounts and use mutual funds in tax-deferred accounts.
It's important to note that this isn't an either/or decision. Mutual funds and ETFs can live perfectly happily side by side in a portfolio .
Next steps to consider
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