ETFs vs. Mutual Funds - Which Is Better for You?

ETFs and mutual funds are two different types of investment products. But is one better than the other? Let's dive in.

ETFs vs. Mutual Funds - Similarities

ETF stands for Exchange Traded Fund. As the name suggests, this is simply a fund that trades on an exchange like a stock. The fund holds individual securities like stocks or bonds inside it but trades as a single product with its own ticker. A popular example is VOO from Vanguard, which is an index fund that seeks to track the famous S&P 500 index, roughly the 500 largest publicly traded companies in the United States. ETFs can also be actively managed, such as ARKK, or track a proprietary index, such as SWAN. The first ETF launched in 1993.

Mutual funds are a much older investment product than ETFs. The first mutual fund launched in 1924. Mutual funds and ETFs have a few very similar characteristics. They can both be actively managed or track some index, and they both hold individual securities inside them. As such, the term index fund can describe an ETF or a mutual fund.

Mutual funds and ETFs are available for U.S. and international stocks and bonds, among other assets. Thus both ETFs and mutual funds can both provide instant diversification in a single product, depending on which specific ones you're investing in. This makes mutual funds and ETFs less risky than buying a handful of individual stocks or bonds.

ETFs vs. Mutual Funds - Differences

There are a few key differences between ETFs and mutual funds, though.

The first relates to management style. By sheer numbers, mutual funds tend to be actively managed, meaning managers are using their supposed expertise to try to beat their benchmark, while ETFs tend to passively track some index. That active management may sound enticing, but it's worth noting that over 95% of fund managers fail to beat their benchmark index over a 20-year period.

The first mutual funds were actively managed, with index mutual funds arriving later. The opposite is true of ETFs; they were originally strictly a passively managed product until actively managed ETFs launched in 2008.

Because of this average difference in management style, mutual funds on the whole tend to have greater fees, called the expense ratio, than ETFs. Even the passively managed VFIAX from Vanguard for the S&P 500 has a fee that is 1 basis point (or 0.01%) higher than its ETF equivalent VOO. This fee is expressed as an annual percentage of the amount invested. Mutual funds may also have a sales commission component, while ETFs do not.

Another key difference between mutual funds and ETFs is how they're traded. ETFs can be bought and sold throughout the day during market hours, and their intraday prices can thus fluctuate based on supply and demand. As such, an ETF's price can differ from its NAV, or net asset value. Mutual funds, on the other hand, are bought and sold once per day after the market closes when their NAV is set. This greater flexibility and liquidity of ETFs may be valuable to the investor who wants more control. Just note that in doing so, you may lose some money to the implicit costs of the bid/ask spread of the trade and a market price that is potentially greater than its NAV.

Mutual funds typically have a minimum initial investment requirement of $1,000 or more, as well as potential minimums on future investments. Most Vanguard mutual funds, for example, require a minimum initial investment of $3,000. ETFs have no such requirement and can be bought for the price of a single share, or even fractional shares with some brokers. Consequently, ETFs are much more accessible to new, young investors.

The last major difference between ETFs and mutual funds relates to tax-efficiency. ETFs usually have lower turnover (less trading) and generate fewer capital gains for investors throughout the year compared to mutual funds. The unique ETF creation and redemption process also gives it a tax advantage over mutual funds.

Conclusion - Which Is Better?

Given the above considerations, ETFs are quickly replacing mutual funds, and ETFs are probably going to be the better choice for most investors due to their greater liquidity, tax advantages, and lower fees on average.

An important caveat to note is that you'll only find mutual funds in an employer-sponsored plan (ESP) like a 401k, so you may not be able to avoid them even if you want to.