Exchange Traded Funds vs. Mutual Funds: What’s the Difference?
By Paul Hynes, CFP®
Both Exchange Traded Funds (ETFs) and mutual funds are a type of investment structured to own a “basket” of other investments. Each has different features. One structure is not substantially better or worse than the other. Each investment tool should be evaluated for its own merits, not simply because of the structure of the “basket.” To help you better understand them, let’s compare some of the fundamental similarities and differences between these two types of investment vehicles. Although they can be designed for many different investment strategies, for our example we’ll refer to stock and bond funds.
If you invest in either ETFs or mutual funds, your investment buys into a basket of stocks and/or bonds rather than a single stock or bond. In that regard, ETFs and mutual funds are the same. They’re also similar in that the basket is managed by investment professionals. There is a cost of administering and managing either sort of fund. Generally, that’s the extent of the similarities. Now let’s examine the key differences.
How you buy and sell shares of each type of investment is a key difference. An ETF is a fund that behaves and trades like a stock. It is listed on a stock exchange, you can buy or sell shares of the fund using a brokerage account, and the price varies while the stock market is open for trading. That variation is called intraday pricing. The market price can, and usually does, vary from the underlying net asset value—either higher or lower. In some cases you pay a transaction fee or commission when you buy or sell ETF shares.
On the other hand, a mutual fund is bought or redeemed directly from the mutual fund itself, not on an exchange. The price is calculated once a day at the end of the day and is equal to the net asset value. There isn’t any intraday pricing for mutual fund shares. If you buy or sell them in a brokerage account, the transaction is brokered directly with the mutual fund on your behalf. And, there may be a transaction fee or commission when you buy or sell a mutual fund.
The cost of management may be a key difference, although not for the reason some people think. As mentioned, both types of funds have a cost of administration and management. This cost, when quoted as a percent, is called the expense ratio. Most ETFs are index funds, also known as passive investment funds, which typically have a lower expense ratio. That’s because index funds, such as the Standard & Poor’s 500 Index®, are not actively managed. Thus the expenses are lower. However, many mutual funds are also index funds. So, the real difference in cost isn’t between the two sorts of fund structures but rather how each fund is managed—actively or passively.
There is also a key difference in how you may be taxed. Taxes vary from person to person and this part can be tricky. When you sell either an ETF or a mutual fund at a higher price than what you paid, you will have a capital gain and may pay taxes on that gain. So, no differences on that side of the transaction. However, with a mutual fund, if the investment manager sold some of the fund's underlying investments at a gain, then the fund might pay a distribution of net capital gains to all the fund owners who may have to pay taxes on those gains. An ETF generally will not pay a capital gains distribution because of the way an ETF is constructed and redeemed. Note that if you own either an ETF or mutual fund in a tax-deferred account, such as an IRA or 401(k), gains on the transaction are not taxable. In those accounts, taxes are determined by what you take out and when you take it.
ETFs and mutual funds may share things in common, but as in every investment situation, investors should carefully weigh their individual goals and circumstances. Tax considerations should be discussed with your tax professional. Call us with any questions about your specific situation.