What's the difference between a mutual fund and an ETF? Which should you buy—a mutual fund or an ETF? What are the deciding factors? In this article, we'll take a deep dive into mutual funds and ETFs. I’ll define the two terms, talk about FOUR key differences, and even give you a glimpse into the book I wrote: Mutual Funds Are So 1999: How & Why ETFs Have Disrupted the Trillion Dollar Mutual Fund Industry.
So, What Are Mutual Funds and ETFs?
According to Investopedia, an Exchange Traded Fund (ETF) is: “A type of security that involves a collection of securities—such as stocks—that often tracks an underlying index, although they can invest in any number of industry sectors or use various strategies.”
A mutual fund is: “A type of financial vehicle made up of a pool of money collected from many investors to invest in securities like stocks, bonds, money market instruments, and other assets. A mutual fund’s portfolio is structured and maintained to match the investment objectives stated in its prospectus.”
The long and short of it is this: Both mutual funds and ETFs are a group of investments with a collective purpose.
Difference #1: Fees/Expense Ratio
Nearly every single mutual fund has some sort of fee involved in it somehow. The associated fee (or expense ratio) differs between whether or not your mutual fund or ETF is actively managed or passively managed. Actively managed simply means that a manager(s) buys and sells on a daily, weekly, monthly basis on your behalf. Passively managed means that the mutual fund or ETF is following a benchmark they’re associated with (Dow Jones, S&P 500, NASDAQ, etc.).
On average, an actively managed mutual fund charges 1.09% annually. A passive mutual fund charges an average rate of 0.79%. On the flip side, a passively managed ETF costs roughly 0.57% annually versus 0.6% for an actively managed ETF. The cost differences make sense—after all, if someone is actively managing the group of investments, they have to get paid.
Difference #2: Management Style + Performance
Hypothetically speaking, the running theory is that if you pay more, you should do better. Right? So I did some digging and took a look at the SPIVA US scorecard, which attempts to look at performance differences between actively managed funds and passively managed funds.
According to this report, 70% of domestic stock funds lagged the S&P Composite 1500 making for the 4th worst performance since 2001. Actively managed funds did NOT have a good year last year. Looking over the performance for 15 years, only 10% of actively managed funds beat the S&P 500.
Keep listening as I dissect the numbers and share how different sectors performed in actively and passively managed mutual funds and ETFs.
Difference #3: How Mutual Funds and ETFs Are Bought and Sold
I’ll cover this briefly, but if you want an in-depth look at how these are bought and sold, be sure to check out my book!
An ETF trades throughout the day on an exchange (trading platform) just like a stock. You can buy an ETF at 10:30 and sell it at 10:45. You’ll know what monetary amount you’re buying and selling it for. You can also set a limit order so that your ETFs sell at a minimum amount (if the value is dropping) or a maximum amount (if the stock is rising).
It is NOT the same with a mutual fund. You’re buying directly from and selling to the mutual fund company. A mutual fund doesn’t sell instantly and you don’t know what price you’re selling at. Typically, you don’t know the price you’re getting until after the stock market has closed. You cannot set limit orders with mutual funds. When you sell them, you choose the number you’re selling and hope for the best.
Difference #4: Tax Efficiency
When mutual funds sell investments, any profits are passed on to the funds’ shareholders via capital gains distributions. If you have an actively managed fund you WILL pay taxes on them (though it is a little different with a Roth IRA or qualified accounts).
Capital gains are extremely unlikely with ETFs due to how they’re constructed and traded. In this episode, I share THREE different examples going back 10-15 years where ETFs have NOT made capital gains. Passively managed ETFs are the most tax-efficient of mutual funds and ETFs.
So how do you decide which one to buy? The bottom line is this: it depends on what you’re trying to accomplish, what type of account you have, your risk tolerance, and the goals of the investment. Do your research and make the best choice for you. Reach out to your financial advisor—or myself—if you have any questions.
If you want to learn why I believe the ETF structure is superior to the mutual fund structure, check out my book: Mutual Funds Are So 1999: How & Why ETFs Have Disrupted the Trillion Dollar Mutual Fund.