What’s the Difference Between Mutual Funds and ETFs?

Mutual funds and exchange-traded funds (ETFs) are two ways to diversify your investments  and maintain a healthy, balanced portfolio. Picking individual stocks can be both risky and expensive, but funds offer a way to invest in a number of stocks simultaneously – a strategy which is usually both cheaper and better-performing over time. Many experts recommend putting your retirement contributions into mutual funds or ETFs for easy diversification, but which one is right for you? We’ll take a look at the similarities, differences, and reasons to choose on option over another.

ETFs vs. mutual funds: A comparison chart

Deciding Between Mutual Funds and ETFs

You don’t always have the option to pick between mutual funds and ETFs. If you’re investing within an employer-sponsored retirement account, your plan might not offer both types of funds. But if you’re managing a retirement fund with an IRA, or investing in a non-retirement account, you can choose from thousands of different funds. When deciding between a mutual fund and ETF, here are some questions to consider:

• How much money can you invest?

• Do you want to make regular contributions?

• How much are you willing to pay in fees?

• Are you interested in derivatives trading?

• Do you want an actively or passively managed fund?

• What are the tax implications?

With those criteria in mind, we’ll walk through the similarities and differences between ETFs and mutual funds. Regardless of what type of fund you invest in, you’ll want to keep a close eye on the fund’s performance and its expense ratio.

Overview of mutual funds and ETFs

Both mutual funds and ETFs allow you to buy a small piece of hundreds, or thousands, of different stocks, bonds, or other assets. For example, let’s say you want to invest in tech stocks. Rather than buying shares from Apple, Microsoft, Facebook, etc. individually, you can invest in the Vanguard Information Technology Index Fund (VITAX), which owns shares of various tech companies. Funds may have a narrow focus, such as U.S.-based energy companies, or may be as broad as international companies in general. In exchange for providing convenience and investing expertise, fund managers levy fees, usually an annual percentage of the funds you invest. There are different rules governing mutual funds and ETFs, and we’ll get into those later. For now, we’ll talk in broad strokes about the three types of funds to consider: ETFs: In this investment vehicle, the fund buys all the stocks in a particular index. Take the S&P 500 index, which is often used as a benchmark for how U.S. stocks, or “the market,” is doing. Vanguard, SPDR, iShares and many more offer ETFs that exactly track the S&P’s stocks and allocation. Since there isn’t much decision-making or maintenance required (they’re just mirroring an existing index), ETFs typically have low fees. Actively managed mutual funds: Here, fund managers pick the companies they think will perform best in a given category. For example, an actively managed clean technology mutual fund would be comprised of stocks that the fund’s analysts think will provide the best returns. Since active funds require more overhead and (theoretically) allow you to benefit from their managers’ experience, they usually have higher fees. Index (passively managed) mutual funds: If actively managed funds and ETFs had a baby, it’d be index mutual funds. Like ETFs, index mutual funds track an existing index. However, they’re still subject to the same rules as actively managed mutual funds. We’ll get to those rules in a bit, but for now, just remember that index mutual funds are passively managed and therefore typically lower-fee than actively managed ones.

The difference between ETFs and mutual funds

With that overview in mind, we’ll talk about the differences between ETFs and mutual funds (both passive and active).

How much money can you invest, and from where?

Mutual funds often have a minimum starting contribution requirement, which may range from $1,000 to several hundred thousand dollars. You could bypass the minimum by investing in a mutual fund through an employer-sponsored retirement account, but otherwise you’ll need to invest at least the minimum to purchase the mutual fund. (There are a few exceptions – for example, you can buy Vanguard ETFs without a minimum from a Vanguard account, and through the Robinhood app.) ETFs don’t have minimum contribution requirements, though you may need to pay the broker a fee each time you buy or sell shares. You can buy mutual funds directly from a mutual fund company, such as Vanguard or Fidelity, without needing a brokerage account. ETFs, on the other hand, are listed on exchanges, so you’ll need a brokerage account to invest in them. Brokerage accounts let you trade stocks, bonds, options, etc., in the same way that a checking account lets you deposit and make transactions. Opening an online brokerage account is fairly straightforward (though you’ll probably need to provide basic demographic information as well as your Social Security or tax identification number, your net worth and a few other details). However, you’ll want to do some research: brokers can charge account fees, require minimum opening deposits, and charge commissions every time you make a trade (though many brokers offer commission-free ETF trades). You can learn more about brokerage accounts here.

Do you want to make regular contributions?

Once you’ve bought into a mutual fund, you may be able set up regular purchases for a particular dollar amount, such as $50 per month, regardless of the mutual fund’s NAV or account minimum. ETFs don’t have an account minimum, but you will need to buy complete shares in the fund to increase your contribution, and you may have to pay trading fees.

Do you want an actively or passively managed fund?

As we mentioned above, there are both actively and passively managed mutual funds, but ETFs are strictly passively managed. If you’re looking for an active fund, proceed with caution: only 20% of actively managed blue chip funds outperformed the S&P 500 from 2005-2015, and that’s before taking into account the higher fees. Most experts recommend that casual investors choose an index mutual fund or ETF over an actively managed fund.

How much are you willing to pay in fees?

Both mutual funds and ETFs typically charge investors for operating expenses, as a percentage of the funds you invest. The expense ratio tells you how much you’ll pay in annual fees as a percentage of your investments. As we mentioned above, ETFs and index mutual funds usually have lower fees than actively managed mutual funds. Passive funds (both ETF and mutual) charged an average of 0.2% in 2014, compared to 0.79% for active funds. This difference of less than 1% may seem small, but it can have a significant impact on the growth of your investments. Some funds levy additional charges, including purchase, redemption, marketing and distribution (12b-1), and front- and back-end loads. (Check out this guide to mutual fund fees for more detail). Mutual funds are more likely to charge these fees, but not all do. While ETFs rarely have those fees, you may need to pay your broker each time you buy or sell shares. When buying and selling ETFs, particularly thinly traded ETFs, investors also must contend with the bid-ask-spread – the difference between the price someone wants to sell an ETF for and the price the buyer wants to pay.

Are you interested in derivatives trading?

ETFs allow for much more fancy-footwork trading than mutual funds do – they trade fairly similarly to individual stocks, so you can place limit or stop orders (make a purchase or sale if the ETF reaches a certain price), buy on margin (borrow money to buy shares), or buy and sell derivatives based on the fund. You can open a brokerage account and buy or sell an ETF whenever the markets are open, and prices fluctuate throughout the day. Mutual funds are comparatively plain-vanilla: They’re bought or sold just once per day, when the trading day ends at 4 p.m. Eastern time. That’s also when mutual fund prices – net asset value, or NAV – are set. You can’t place limit or stop orders for mutual funds, short mutual funds, or buy them on margin.

What are the tax implications?

If you’ve invested in an active mutual fund that sells its underlying assets for profit, you may have to pay capital gains taxes every year. Index funds and ETFs, however, have few internal trades and typically incur fewer capital gains taxes. As a result, ETFs tend to be more tax-efficient.

Summary: Which fund is best for you?

Mutual funds and ETFs offer investors an easy way to invest in a variety of assets or track an index with a single purchase. While they share some characteristics, particularly when comparing passively managed index mutual funds and ETFs, they’re traded differently and may charge investors different fees. If you’re looking for an actively managed fund or want to make regular equal-value contributions, mutual funds may be a better fit. ETFs offer lower initial investment requirements, but you’ll have to grow your investment by buying complete shares, and you may need to pay a trading fee each time you make a purchase. In either case, try to minimize or avoid fees, as they can substantially decrease the long-term value of your investments.