ETFs vs. Mutual Funds: What is the difference?

Many investors find ETFs and Mutual Funds simple and useful investment vehicles. Exchange-Traded Funds (ETFs) and Mutual Funds allow you to invest in a basket of securities which are often based on a guiding philosophy, investment objective, sector, or country. The similarities and differences between these two investment vehicles are important to understand.

Let’s start with the general similarity. By purchasing shares in ETFs and Mutual Funds, investors get indirect exposure to the securities that the fund owns. ETFs are collections of a wide variety (hundreds or thousands) of stocks and/or bonds, managed in a single fund. Meanwhile, Mutual Funds collect assets from shareholders which provide investors the tools to build a varied portfolio with diversified securities. Additionally, Mutual Funds are further divided into open-end funds and closed-end funds (CEF), of which the latter is more complex. In this piece, we’ll discuss  the difference between ETFs and Mutual Funds. 

What Role Do ETFs and Mutual Funds Play in Diversification?

ETFs and Mutual Funds allow for investments in a wide variety of securities. This helps investors build a varied portfolio that they might otherwise have difficulty acquiring or managing on their own.

For example, if an ETF has a basket of over 100 equally weighted healthcare securities, an investor would be able to gain the benefits of that diversified basket of securities just by buying a share of the ETF. Without buying an ETF it would be much more difficult for the investor to buy and keep track of all those securities individually.

Furthermore, a benefit of ETFs and Mutual Funds regards their distribution of different kinds of sectors and securities. This distribution allows investors to easily diversify among different asset classes, and sometimes with securities that they might have difficulty accessing as individual investors.

Mutual Funds vs ETFs: Top 4 Differences

1. Management Style

The first major difference between ETFs and Mutual Funds is their management style. ETFs are almost always passively managed and set to match a specific index or investment style. Mutual Funds can be passively or actively managed. Actively managed mutual funds have a team that makes buying and selling decisions at the stock or bond level, in an attempt to outperform a specific benchmark.

2. Liquidity

The second important difference between the two types of funds is their liquidity. ETFs are traded on an exchange, which means they can be acquired and disposed of any time during trading hours, as well as during pre-market and after-market trading. Mutual Funds, in contrast, can only be bought and sold at one specific time during the day. The Mutual Fund will collect orders throughout the day and then process them all at a set time after the market closes (see also liquidity risk).

3. Price Information

Because ETFs are traded on an exchange, their price is available in real-time for investors. Mutual Funds are only priced at the end of the trading day. This creates some uncertainty as to the exact price at which Mutual Fund shares will be sold. However, it also reduces volatility during the trading day for the shares held.

4. Net Asset Value (NAV)

Mutual Funds are always bought at their NAV, which equates to the total average price per share of all the securities that the fund owns. ETFs, however, can trade at a premium or discount to the actual value of the securities, which makes pricing an important factor to keep track of.

What are the Benefits and Drawbacks of Investing with ETFs and Mutual Funds?

As an investor, Mutual Funds and ETFs allow you to easily access a large and diversified basket of securities in a simple and straightforward fashion. Furthermore, investors can make different combinations of ETFs and Mutual Funds to build their own investment strategies and portfolios.

However, there are several drawbacks and risks to take into account. The first are the fees involved. Mutual Funds and ETFs charge fees for their services, which for some mutual funds can be as high as 1 or 2% annually.

The second drawback regards structure. It is important to look carefully at how ETFs and mutual funds are structured in terms of (1) the types of risks they carry, (2) how they weight different securities in their portfolio, and (3) as how strictly they stick to their investment guidelines. For example, two utility ETFs can vary greatly in the stocks they own, and two utility Mutual Funds can vary even more so in their composition, risk, and style.

Finally, one that is often overlooked, are the drawbacks resulting from tax treatment on for Mutual Funds and ETFs. ETFs can be more tax efficient when compared to traditional Mutual Funds, as holding an ETF in a taxable account will generate fewer tax liabilities than holding a similarly structured Mutual Fund in the same account.

Investing in ETFs and Mutual Funds

ETFs and Mutual Funds offer investors an incredible opportunity to broaden their investment opportunities, but they come with significant risks too. It is important to understand the types of risks, as well as your risk capacity and risk tolerance when making these decisions. A fiduciary financial advisor can help identify if investing in ETFs or Mutual Funds is the best choice for your portfolio, as well as assist you with the management of your investments.