The United States financial markets feature two main investment vehicles—ETFs vs. mutual funds. As of early 2023, these together hold $60.1 trillion in regulated open-end funds. Mutual funds have existed since 1924, while ETFs emerged much later in 1993. ETFs’ growth has been remarkable, yet mutual funds maintain a larger market share, with $25 trillion compared to ETFs’ $8 trillion in 2023.
Beginners looking at ETFs vs. mutual funds should consider trading flexibility, cost structure, and investment goals. Most mutual funds require higher minimum investments, ranging from $500 to $5,000. ETFs are a great way to get tax benefits through their unique creation/redemption process. The trading mechanics also differ significantly—investors can trade ETFs like stocks throughout the day, while mutual fund prices update just once daily.
This article explains ETFs vs. mutual funds’ fundamentals, their mechanisms, and their suitability for various investment strategies. A solid grasp of these investment vehicles helps beginners make smarter decisions about their money’s long-term growth potential.
What Are ETFs vs. Mutual Funds?
Mutual funds and ETFs are investment vehicles that pool money from many investors. They operate differently, and each has its own advantages.
What Is a Mutual Fund?
A mutual fund combines the capital of several participants to purchase a variety of products, including bonds, stocks, and short-term loans. Each share shows an investor’s ownership in the fund and right to any income it makes. The fund’s portfolio combines all these holdings, and SEC-registered investment advisers manage it.
Fund managers do the research and watch performance so investors don’t have to. These funds make investments in businesses of various kinds and sectors. This gives investors instant diversification they’d find hard to achieve on their own.
Fund prices update once daily after markets close. The price comes from the net asset value (NAV) of all holdings minus expenses divided by total shares. About 53% of American households owned mutual fund shares by the mid-2020s, with Gen Z making up 35% of these households.
Related Article: Choosing Between Secured vs Unsecured Loans: A Complete Guide
What Are ETFs?
ETFs are similar to mutual funds being that they gather investors’ money to buy a basket of securities. But ETFs trade on stock exchanges all day long just like individual stocks. When you buy ETF shares, you don’t own the actual assets – you own units in the fund.
The ETF provider owns the underlying assets and creates the fund to track their performance. ETF shares trade at market prices that sometimes differ from their assets’ actual value, even though they’re designed to track these assets or indexes.
Most ETFs are passive investments that want to match specific indexes, sectors, or asset classes. This hands-off approach usually means lower management costs than actively managed funds. ETFs give investors more flexibility – they can use different trading strategies like limit orders, margin buying, and hedging.
ETFs vs Index Funds
People often mix up “ETF” and “index fund,” but they’re not the same thing. The only requirement for an index fund is that it tracks a market index; it can be ETFs and mutual funds.
The biggest difference is in how they trade. Index mutual funds price and trade once daily after markets close, while ETFs trade all day long at prices that change minute by minute. ETFs also show their holdings every day, while index mutual funds usually share this information monthly or quarterly.
Index ETFs usually cost less than similar index mutual funds. The Investment Company Institute reports that index mutual funds charged 0.05% on average in 2024, while index equity ETFs charged 0.14%. Some S&P 500 ETFs charge as little as 0.03% per year.
ETFs handle taxes better, too. They create fewer capital gains because of how they’re built and how little they trade. They also use a special ‘in-kind’ process for creating and redeeming shares that leads to fewer capital gains distributions than index mutual funds.
How They’re Built and Managed?
ETFs vs. Mutual Funds
The mechanisms of ETFs and mutual funds show the most important differences in their operation, management, and market interaction.
Fund Structures: Open-End vs Closed-End
Mutual funds typically work as open-end funds. They continuously issue and redeem shares directly with investors at the net asset value (NAV). Investors have the option of purchasing shares through a broker or straight from the fund company. Closed-end funds work differently. They issue a set number of shares through an initial public offering (IPO) and trade on exchanges like stocks, often at prices above or below their NAV.
ETFs combine features of both types. They work as open-end funds but trade like closed-end ones. This hybrid structure gives ETFs special features. They can create new shares or redeem existing ones through authorised participants while trading on exchanges throughout the day.
Management Styles: Active vs Passive
The management approach sets many investment products apart. Active management lets fund managers make specific investment decisions to beat a measure index. These managers research thoroughly, pick securities, and adjust holdings based on market conditions. This usually leads to higher expense ratios and turnover rates.
Passive management tries to match the performance of an underlying index by holding the same securities in similar proportions. This requires minimal oversight and results in lower costs and less turnover. ETFs and mutual funds can use either style. ETFs mostly use passive strategies, with approximately 95% of ETF assets under passive management.
Creation and Redemption: ETFs vs. Mutual Funds Process
Creation and redemption methods are the most significant operational difference between these investments. Mutual fund transactions happen directly between investors and the fund company. All shares are created or redeemed at the day’s final NAV.
ETFs use a special “in-kind” creation/redemption process with authorised participants (APs), usually large financial institutions. Instead of cash transactions, APs exchange security baskets for ETF shares (creation) or ETF shares for underlying securities (redemption). This happens in large blocks called “creation units,” usually containing 50,000 shares.
This unique system gives ETFs significant tax benefits. It reduces the need to sell securities for redemptions, so capital gains distributions to shareholders stay low.
Trading Mechanics and Flexibility
ETFs vs. mutual funds differ primarily in how they are purchased and sold, which influences the degree of flexibility that investors have in their trading strategy.
ETFs: Real-Time Market Trading
ETFs work with a two-layer liquidity structure that gives investors excellent trading flexibility. These instruments trade on stock exchanges throughout the day, just like regular stocks. This lets investors react right away to market news and trends. ETF prices change nonstop during market hours. They show both bid prices (what buyers will pay) and ask prices (what sellers will accept). Live pricing helps traders complete their transactions quickly instead of waiting until the end of the day.
ETFs get their liquidity from two places – the primary market through underlying securities and the secondary market via exchange trading. This dual structure helps ETFs work as “shock absorbers” when trading gets volatile. Buyers and sellers can trade directly on the exchange without disrupting the underlying securities.
Mutual Funds: NAV-Based Daily Trading
Mutual funds use a totally different trading approach. These funds process all transactions once per day after markets close at 4 p.m. Eastern Time. The price you get is based on the fund’s net asset value (NAV). This calculation takes the fund’s assets, subtracts what it owes, and divides by the number of shares outstanding.
The timing of your order during the day doesn’t matter – everyone gets the same price based on the closing NAV. Most funds figure out their NAVs between 4 p.m. and 6 p.m., with specific deadlines to process orders the same day. To name just one example, orders that come in after 3:00 p.m. usually process the next day’s NAV.
Advanced Trading Features in ETFs
ETFs go beyond simple buying and selling by offering sophisticated trading options you won’t find with mutual funds. Investors can use limit orders to set maximum purchase or minimum selling prices, stop orders that trigger at specific price points, and even stop-limit orders for exact control. ETFs also let you trade on margin, sell short, and use various other advanced strategies.
If you want specific market exposure, leveraged ETFs can multiply your returns (usually 2x or 3x) of their target index’s daily performance. Inverse ETFs move opposite to their measure, so they might go up when markets fall.
Costs, Fees, and Tax Implications
Beyond their structural differences, the fee structure and tax treatment of ETFs vs. mutual funds can significantly affect investor returns over time.
Expense Ratios: Mutual Fund vs ETF
The expense ratio shows what percentage of fund assets goes toward administrative and management costs. ETFs usually cost less to run than mutual funds. The average ETF expense ratio was 0.51% in 2023, which is about half of what mutual funds charge at 1.01%. This holds no matter the investment style – index ETFs cost 0.44% versus 0.88% for index mutual funds, while active ETFs run at 0.63% compared to 1.02% for actively managed mutual funds.
Fund fees have dropped a lot in the last two decades. The average annual fund fees fell to 0.36% in 2023 from 0.87% in 2004. Michael McClary, Chief Investment Officer at Valmark Financial Group, puts it simply: “The one thing you can control is fees”.
Tax Efficiency: In-Kind Redemption vs Capital Gains
ETFs’ tax efficiency might be their most overlooked advantage. They create far fewer capital gains distributions than mutual funds because they use a unique “in-kind” redemption system. To put this in perspective, only 2.5% of ETFs distributed capital gains in 2023, while 31.5% of mutual funds did the same.
Hidden Costs: Bid/Ask Spreads and Load Fees
Investors should look beyond expense ratios. ETFs come with bid/ask spreads—the gap between buying and selling prices. This hidden cost ranges from 0.01% to 0.25%. Less popular ETFs or market volatility can make these spreads bigger.
Mutual funds have their extra costs. These include sales loads up to 8.5%, account fees, and charges for early withdrawal. Some funds take fees upfront, others when you sell, and many charge yearly marketing fees up to 1%.
Choosing the Right Option for You: ETFs vs. Mutual Funds
ETFs work best if you trade actively and want intraday transactions, stop orders, or limit orders. They work especially when you have tax concerns, as only 2.5% of ETFs distributed capital gains in 2023 compared to 31.5% of mutual funds. ETFs also make sense if you want exposure to specific industries or commodities. Most ETFs disclose their holdings daily, which helps you make better-informed decisions.
Mutual funds shine if you invest regularly through methods like dollar-cost averaging. Their fractional shares feature lets you invest exact amounts each time. These funds also excel at automatic investment features. You can schedule regular contributions and avoid the hassle of timing your investments. Many investors appreciate this “set-and-forget” convenience.
Conclusion – ETFs vs. Mutual Funds
ETFs and mutual funds show distinct differences that affect investment outcomes. These investment tools help build wealth differently, each with unique features that work better for different types of investors.
ETFs come with clear cost benefits. Their expense ratios are about half of what mutual funds charge. The in-kind redemption process gives ETFs better tax advantages and helps you keep more of your returns. Active traders love ETFs because they can trade them throughout the day and use advanced order types that mutual funds don’t offer.
Mutual funds also have their own benefits. They let you buy fractional shares, which means you can invest exact dollar amounts. This works great when you want to make regular contributions through automatic investment plans. The simple “set-and-forget” approach makes mutual funds perfect for beginners or people who don’t want to manage their investments actively.
Are ETFs suitable for beginner investors?
ETFs can be a great option for beginners. They offer broad market exposure, often with lower costs than mutual funds. For novice investors, ETFs tracking major indices like the S&P 500 provide instant diversification across large companies, aiming for long-term returns. However, it’s important to consider factors such as risk tolerance and expense ratios when selecting ETFs.
How do ETFs and mutual funds compare in terms of costs?
ETFs often have have lower expense ratios compared to mutual funds. ETFs also tend to be more tax-efficient due to their unique creation and redemption process, resulting in fewer capital gains distributions to investors.
Can I set up automatic investments with ETFs and mutual funds?
Mutual funds are generally better suited for automatic investment plans. Because they make it possible to buy fractional shares, it’s simple to make regular investments in set amounts. While some brokers offer automatic investment options for ETFs, mutual funds traditionally excel in this area, providing a “set-and-forget” convenience that many investors appreciate.