At first glance, mutual funds and ETFs might seem very similar. They are both diversified portfolios that can cover hundreds or thousands of securities. They are both overseen by professional money managers. However, there are some differences between mutual funds and ETFs. It's good to know the pros and cons of mutual funds and ETFs.
What’s the difference between mutual funds and ETFs?
There are significant differences between mutual funds and ETFs. The minimum initial investment for an ETF is based on the price of one share, while a mutual fund’s minimum is based on a flat dollar amount, according to Vanguard. So, if you are interested in lower investment minimums, ETFs might be the way to go.
You might also choose an ETF if you want more control over your portfolio. ETFs offer real-item pricing, while mutual fund share prices are calculated after the end of each trading day. Also, ETFs offer more sophisticated order types “that give you the most control over your price,” according to Vanguard.
However, mutual funds allow you to set up automatic investments and withdrawals. ETFs don’t have that capability.
The cost is also an important consideration.
Why are mutual funds cheaper than an ETF?
Fidelity says that ETFs are usually cheaper than mutual funds for a variety of reasons. The firm says, “Mutual funds charge a combination of transparent and not-so-transparent costs that add up.” Fidelity also says, “It’s simply the way they are structured. Most, but not all, of these costs are necessary to the process. Most could be a little cheaper; some could be a lot cheaper. But it’s nearly impossible to get rid of them altogether. ETFs have transparent and hidden fees as well—there are simply fewer of them, and they cost less.”
For example, in addition to transaction fees, distribution charges, transfer-agent costs, and capital gains tax bills, mutual funds charge a sales load of 1 percent to 2 percent, which compensates brokers for their efforts. In contrast, ETFs don’t charge a sales load. They charge brokerage commissions that are “generally are no higher than $20,” according to Fidelity.
Usually, ETFs have lower expense ratios because they track indices like the S&P 500 Index. However, as Investopedia points out, actively managed funds have higher expense ratios than passively managed funds.
Nerdwallet says ETFs are generally more tax-efficient than mutual funds. Mutual funds tend to incur higher capital gain taxes than ETFs. Mutual funds trade more often. Capital gain taxes are passed to all of the shareholders in the mutual fund.
ETFs have become the “darlings of the investment world” due to their benefits, according to Nerdwallet.
Nerdwallet explains, “Their growth has been rapid.” The site says, “In 2003, there were only 123 ETFs to invest in. Today in the U.S., there are more than 2,000 to choose from, holding more than $4 trillion in assets.”
If you’re deciding between mutual funds and ETFs, it's important to see how each option aligns with your investment goals and investment style. Also, don't forget about the fees!