ETFs vs. MUTUAL FUNDS – A COMPARISON

Exchange Traded Fund (ETF): an exchange-traded fund is an investment vehicle that pools a group of securities into a fund. It can be traded like an individual stock on an exchange.

Mutual fund: a mutual fund is a professionally managed portfolio of stocks, bonds and/or other income vehicles devoted to a specific investment strategy or asset class. When investors buy shares in the fund, the mutual fund company pools that money to make investments on their behalf. A share represents a portion of the fund's holdings.

Exchange Traded Funds (ETFs) and mutual funds are two of the most popular ways for investors to access the financial markets. Before getting to the differences, here are three critical elements ETFs and mutual have in common:

Diversification

One, both ETFs and mutual funds are financial instruments that typically own a basket of securities rather than individual stocks or bonds, providing an important benefit to investors: diversification. Although everyone’s financial goals are unique to them, the primary goal of investing is typically to generate the highest possible return for the lowest risk. By spreading your investments across asset classes, geographies and sectors – not putting all your eggs in one basket, that is – you may lower the overall risk to your portfolio. That’s because the poor performance of one investment could be offset by stronger performance in another, and vice versa. Diversifying is one of the best ways for investors to navigate fast-changing markets and stay the course to pursue their long-term financial goals.

Strategic options

Two, both ETFs and mutual funds can be either “index” funds, meaning they are designed to track the performance of an index, like the S&P 500, or “active”, where the managers have discretion to buy and sell different assets when they see potential opportunities. Both active and index funds are professionally managed, but active ETFs and mutual funds typically require more monitoring and trading by the managers, which can result in higher fees.

Variety of Investing Styles

Three, both mutual funds and ETFs come in a wide variety of assets and investing styles. For instance, you can find both equity ETFs and mutual funds that invest in specific sectors, such as technology, as well as ones that provide exposure to international stocks, including regional, country-specific and sector-focused ETFs. In addition, there are equity ETFs and mutual funds that focus on factor-based strategies (a.k.a. “smart-beta” investing) such as quality or momentum.

The same variety of options – in both mutual funds and ETFs – can be found in other asset classes, including bonds and commodities. There are also mutual funds and ETFs that aim to offer “all in one” portfolio solutions, meaning combinations of stocks, bonds and other assets. iShares Core Allocation ETFs, for example, make it possible to invest in a diversified portfolio for as little as $1 if you buy fractional shares of iShares at Fidelity. For all their similarities, there are big differences between ETFs and mutual funds, which potentially have major implications for investors.

As with stocks, you can trade ETFs and mutual funds directly through your brokerage account, or via a financial advisor. However you may choose to trade them, mutual funds are bought and sold directly from the mutual fund company at the current day’s closing price. As a result, everyone who places a “buy” or “sell” order for a mutual fund on a given day will get filled at the same price, regardless of what time of day their order is placed.

ETFs, on the other hand, are traded on exchanges throughout the day just like stocks. That means when you place an order to buy or sell an ETF, you can see the current market price at which it’s trading — as well as the bid-ask spread, meaning the price range at which other investors are willing to buy or sell it.

And just like stocks, you can trade ETFs using limit orders where you set the price at which you’re willing to buy or sell. Limit orders can be particularly helpful to investors during periods of heightened volatility or less-than-normal liquidity. As the name implies, “limit” orders can be a useful tool for investors who want to have more control over the price they pay or receive for an ETF.

Similarly, you can place a stop-loss order on an ETF you already own. Stop-loss orders — which trigger the sale of an asset if it reaches a certain price — can help prevent you from losing paper profits or suffer major losses during periods of acute market stress. A stop-loss order can be set as a fixed price or as a percentage of the current market price. For example, you can place a stop-loss order at $10 per share or at 10% below the current market price. The drawback of a stop-loss order is the risk of a sale being triggered by a temporary price fluctuation which could cause you to lose out on any potential rebound in the share price.

Tax efficiency

ETFs are designed to be tax-efficient and accounted for just 1% of capital gains distributions in 2023, despite holding 29% of U.S. managed fund assets.² Two key features explain why ETFs can be so tax efficient: Low turnover and ETF shareholders are generally insulated from the actions of other investors.

The majority of ETFs are index funds, which typically trade less frequently than actively managed funds.³ Low turnover means fewer sales of stocks that have risen in price, typically resulting in the generation of fewer realized capital gains. Thus, ETF owners are unlikely to incur capital gains taxes until they sell the investment at a gain.

In addition, because investors buy and sell ETF shares with other investors on an exchange, ETF managers don't have to sell holdings to meet investor redemptions — potentially creating realized capital gains in the process. If you're invested in an ETF, you control when to buy or sell the ETF, making it easier to avoid those higher short-term capital gains tax rates.

Certain traditional mutual funds can be tax efficient and, of course, ETF shareholders can incur tax consequences when they sell, but that tax consequence is not passed on to other ETF shareholders. Mutual funds can make distributions while you’re still invested — and you pay capital gains taxes on those even if you don’t sell. Notably, more than half of active mutual funds paid capital gains in the last five years, but only 16% of active ETFs did.⁴

For investments in so-called qualified accounts like a 401(k) or IRA, you’re generally insulated from the impact of taxation. That is one reason mutual funds have historically been featured in retirement accounts, accounting for 65% of assets in 401(k) plans as of March 30, 2024. (Additionally, the fact mutual funds don’t trade on an intraday basis like stocks may make it easier for 401(k) administrators to manage their record keeping.)

But for investors with taxable (non-qualified) accounts, owning low cost and tax-efficient iShares ETFs can help improve your long-term investment returns, allowing you to keep more of what you earn. Learn more about How asset location can help minimize taxes and maximize returns.

Fees

Whether at the grocery store, the mall or the gas station, a penny saved truly is a penny earned. The same is true when it comes to your investments, where keeping costs low can help you reach your goals sooner. Even small fees can have a big impact on your portfolio because not only is your balance reduced by the fee, you also lose any potential return you would have earned on the money used to pay the fee. ETFs typically cost less than comparable mutual funds (40% less on average). For mutual funds, transaction fees may include sales loads (or sales charges) or redemption fees. These are paid directly by investors.

Buying an ETF is also more cost effective than buying the same basket of securities individually. ETFs are widely available commission free on most online brokerage accounts as well as through financial advisors.

In all funds, there are two types of fees to watch: transaction fees and the fees included in the fund’s expense ratio.

The expense ratio represents the operating costs of a fund divided by the average dollar value under management as of the fund’s fiscal year end. The expense ratio (often identified as a percentage of the fund’s assets) is calculated annually and reported in the fund’s prospectus. The largest and most variable part of these costs is usually the fee paid to the fund managers — the "management fee".⁵

Other aspects of these operating costs can include custodial services, recordkeeping, legal expenses, acquired fund fees and expenses (if the fund invests in other funds), accounting and auditing fees, or a marketing fee (called a 12b-1 fee). Operating expenses are taken out of the fund itself and therefore lower the return to the investors. In general, funds that pursue an active investment strategy will have higher operating costs than passive funds.

Since fees vary so much across funds, investors should take time to understand all the fees associated with a fund they might purchase.

Transparency

ETFs generally disclose their holdings on a daily basis. Mutual funds, on the other hand, generally disclose their holdings on a quarterly basis.

Having (near) real-time access to information about which stocks, bonds or other assets an ETF holds is one of the big benefits of the investment vehicle, and a clear difference to traditional mutual funds.