ETFs and mutual funds are two of the most common options for investors looking for low-risk and high returns. Both types of investment funds allow investors to pool resources with other investors to invest in a wide variety of assets so they can create long-term wealth reliably.
Marko Zlatic from WhiteBoard Finance explains: “This is similar to offices pooling their money together to buy a lottery ticket and splitting the winnings or a family pooling money together to buy a vacation property.”
While these two investment funds have similarities, you should consider your goals when selecting the right investment for you. Here’s what you need to know before investing in a mutual fund or ETF.
Key Takeaways
- Mutual funds and ETFs are pooled investment funds that lower investment risk through diversification.
- ETFs are typically passively managed, while mutual funds are actively managed.
- Mutual funds typically have higher operational fees and greater investment minimums.
- Mutual fund managers work to beat the average market returns. However, many funds ultimately underperform the market.
What Is an ETF?
ETFs, or exchange-traded funds, are pooled investment funds that can be traded on a stock exchange. The pooled funds go to purchase securities like stocks, bonds, and other commodities.
While ETFs are managed by professional investment advisors, the majority are managed passively. Passively managed funds follow a market index like the S&P 500, rather than attempting to beat the average returns of the market through frequent trades.
Host of the investment YouTube channel Stock Market Living Justin Barker explains one of the benefits of investing in ETFs:
“It’s able to spread its risks over many different stocks. So even if one or two or a handful of them fluctuate wildly, there’s still plenty of other companies in that ETF that are going to be more steady, which makes the whole ETF a lot less volatile.”
Barker believes the ability to trade ETFs on the stock market sets them apart from mutual funds. ETFs trade during regular market hours, allow investors to place stop-loss and stop-limit orders, and permit participation in short sales.
“Let’s say, for example, that it’s right in the middle of the trading day, and you see a big drop happening right at that moment in front of you. You could simply make a purchase and get more of those shares at a cheaper price. You can also do the same thing by selling when prices are up, if you wanted to take some profits,” Barker explains. “This is one of the biggest differences between ETFs and mutual funds because with mutual funds, you can’t trade them like stocks . . . With an ETF, you simply have more control in the moment to take action.”
What Are Mutual Funds?
Just like ETFs, mutual funds pool investor money to purchase a variety of securities. This makes it easier for investors to decrease risk through diversification. Mutual funds are also actively managed by a professional investment expert who trades assets within the fund to achieve maximum returns.
Investment educator Rose Hahn explains, “Mutual funds typically consist of around 90 stocks at a minimum. So, they provide a lot of diversification that would be hard to replicate on your own.”
While Hahn believes having access to expert investors can be a benefit, she also says:
“In return for managing your money, actively managed mutual funds charge an annual fee of 1–2% of your account balance every year. So at 2%, if you invested $10,000 in a mutual fund, $200 of that goes straight into the fund manager’s pocket.”
Unlike ETFs and individual stocks, mutual funds are only traded at the end of the day. Investors can request to cash out their shares at any time, but the price they’ll receive is wherever the value sits at the close of the market that day.
How Are ETFs and Mutual Funds Similar?
- Professionally managed: Mutual funds and most ETFs are managed by investment advisors. This means you don’t have to make numerous individual investments to own a variety of securities.
- Diversification: Investors benefit from owning stocks, bonds, and commodities in numerous industries because the value of the ETF stays steady even if individual stocks within the ETF struggle.
- Dividends: Whether you own ETFs or mutual funds, the company will pass on dividends it receives from individual stocks to you in the form of a fund dividend.
Key Differences Between an ETF and a Mutual Fund
The difference between ETF and mutual fund investing is largely related to the way the funds are traded. While ETFs are traded on a stock exchange, allowing for trading at any time of day, mutual funds are only traded at the close of the day. Just as investors can short sell and place stop-loss or stop-limit orders on individual stocks, ETF investors can do the same. Mutual fund investors, however, do not have this ability.
Here are some other key differences to be aware of:
ETFs
- Traded on a stock exchange: Just as you can with a stock, you can trade ETFs any time of day, and implement stop-loss or stop-limit orders. You also may short an ETF.
- Low investment minimums: You can often invest in an ETF with as little as $50.
- Passively managed: Returns tend to follow the averages of the market.
- Low expense ratios: Operational fees are typically below 0.5%.
Mutual Funds
- Traded at the close of the market: Can only be traded once per day. It’s also not possible to short sell a mutual fund or implement stop-loss and stop-limit orders.
- Actively managed by portfolio manager: Fund managers attempt to beat the average market returns.
- Higher expense ratios: Operational fees are typically between 1% and 2%.
- High investment minimums: Investment minimums are typically between $1,000 and $3,000.
Mutual Funds vs. ETFs: Questions to Consider
What is the minimum investment for a mutual fund vs. ETF?
ETFs do not require a minimum investment. However, most brokers require investors to purchase whole shares of ETFs. Some ETFs are valued as low as $50, so you can begin investing with a small amount of cash.
Most mutual funds have a minimum investment requirement. For example, Vanguard, the largest provider of mutual funds, requires a minimum of $3,000. Other mutual fund providers offer mutual funds with lower minimum investment requirements, typically starting at $1,000 or higher.
Do ETFs or mutual funds have better returns?
Most ETFs follow the average returns of the market. The average annualized return of the S&P 500 was 11.88% between 1957 and 2021, meaning ETF investors will see similar return rates.
Mutual fund managers attempt to beat the average market returns. If your fund’s manager is successful, you could see higher returns than the average returns of the market. However, in a 2022 report from S&P Dow Jones Indices, analysts found that 79% of fund managers underperformed the S&P 500 in 2021, which is the twelfth year in a row the majority of mutual fund managers failed to outperform the market.
Important
Because mutual funds have higher operational fees than ETFs and the majority of mutual funds do not keep up with the average returns of the market, ETFs are more likely to produce higher returns. If you invest in one of the 21% of mutual funds that outperform the market, you could see a greater ROI, but there are increased risks involved.
Are ETFs or mutual funds more tax-efficient?
Mutual funds more frequently trigger capital gains taxes, making ETFs the more tax-efficient investment. Because ETFs are passively managed, there are few trades going on within the fund, meaning capital gains taxes are less common.
Which one offers greater control to investors?
Investors looking for more control should consider ETFs. ETFs allow investors to buy and sell shares throughout the day, while mutual funds can only be bought and sold at the close of the market.
Real-time price changes are always available, making it possible for ETF investors to play a more active role in trading. ETF investors are also able to implement stop-loss and stop-limit orders as well as open short positions, while mutual funds do not allow these things.
Which type of fund is better if I want to set up automatic investments and withdrawals?
While ETFs allow greater control to investors, anyone looking for an investment that they can “set and forget” should invest in mutual funds. Most ETFs do not allow investors to set up automatic investments and withdrawals.
Which fund has a lower expense ratio?
The expense ratio refers to the fees the fund managers charge to investors per year. ETF fund managers do not provide as many services to investors because ETFs are generally passively managed. This means the expense ratio of ETFs is low. Mutual funds are actively managed funds, which causes their expense ratio to be higher.
Make the Choice That Works Best for You
There are pros and cons to each type of investment fund, but the best choice for you depends on your investment objectives. Before you make your decision, do your research and carefully consider your investment strategy to achieve reliable returns and build long-term wealth.
Select an ETF If:
- You want greater control over your investment
- A small investment minimum is appealing to you
- You want greater tax efficiency
Get a Mutual Fund When:
- You want to beat the average market returns and have a high tolerance for risk
- You’re looking for an automatic “set and forget” option
For more investment advice, check out “How to Invest $1,000 Right Now.”