Let's Talk... ETFs vs Mutual Funds

It seems like there is some confusion around exchange-traded funds (ETFs), and mutual funds. I see these terms being used interchangeably a lot, and although they are similar in many ways, there are a few key differences between the two.

Let’s break each one down:

But first, how are they similar?

Both ETFs and mutual funds are a professionally managed collection (or "basket") of individual stocks or bonds. ETFs and mutuals funds can both be index funds, meaning it’s passively managed and simply tries to match the performance of the index (like the S&P 500) by holding the same securities in that index.

One of the main benefits of investing in ETFs or mutual funds is that with the purchase of one fund, you can diversify across hundreds or thousands of stocks or bonds which can lower your overall investment risk.

Trading

You can buy and sell ETFs just like a stock on any major stock exchange (New York Stock Exchange, Nasdaq, and Chicago Board Options Exchange). The value of an ETF changes in real-time throughout the trading day (Monday through Friday 9:30 a.m. to 4:00 p.m. ET) based on the prices of the securities inside it.

Mutual funds, on the other hand, are a little different. Instead of trading like a stock, a mutual fund is bought and sold at the end of the trading day (4:00 p.m. ET) at the fund's net asset value (NAV). NAV is the per-share value of the fund, which is the price investors can buy or sell shares. It’s calculated by taking the total value of all the assets in the mutual fund (stocks, bonds, cash, etc.), subtracting any liabilities (expenses, fees, etc.), and then dividing by the total number of outstanding shares in the fund.

Fees

Since most ETFs are passively managed, they don’t have a lot of overhead and usually offer lower fees.

Some mutual funds are actively managed, meaning a fund manager selects stocks to try and beat the market. Actively managed funds typically have more fees associated with them like a 12b-1 fees (an annual marketing fee) and a load (a broker’s fee). Other mutual funds are passively managed (like most ETFs) and might have lower fees.

Taxes

Similar to a stock, you don’t owe capital gains tax on an ETF until you sell and realize the gain.

Mutual funds are structured a bit different. When you buy into a mutual fund, the fund manager takes your money, pools it together with other investors’ money, and uses the combined pool of money to buy additional shares for the fund. If another investor wants to cash out, the fund manager has to sell a portion of the assets in the fund to get the investor their cash, which creates a taxable event. The fund then passes the taxes to the remaining investors. So you could potentially owe capital gains taxes in a year you haven't sold any shares.

Other considerations

ETFs generally don’t require a minimum investment, while many mutual funds have a minimum requirement that could range anywhere from $1 to $3,000. For example, VFIAX (the mutual fund equivalent of VOO) has a minimum investment of $3,000.

In addition, some brokers (like Vanguard) don’t allow automatic investments into ETFs. So if you want to 'set it and forget it' with a recurring monthly investment, you’ll need to invest in a mutual fund.

Conclusion

At the end of the day, both ETFs and mutual funds aim to achieve the same goal; lower your overall investment risk through diversification with the purchase of a single fund.

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Talk soon,

Darrell