What's the difference between mutual funds and ETFs

You’ve probably heard of mutual funds before. And perhaps you’ve heard of exchange traded funds, or ETFs, too. Both are pooled investment vehicles that let you invest in a single fund that can indirectly provide you ownership of hundreds of individual underlying stocks or bonds.

Mutual funds and ETFs both provide an easy and relatively inexpensive way to get diversified investment exposure. However, there are a handful of important differences between them. When deciding whether mutual funds or ETFs would be better for your investing needs, consider the following:

Investment strategies – If you’re looking for an “active” investment strategy – one where the fund’s portfolio managers look to pick individual securities they think will outperform the broader financial market(s) – you’ll likely have to use mutual funds. ETFs almost exclusively use “passive” investment strategies – where the fund simply seeks to replicate the holdings of a particular index or sector.

Fees – Both mutual funds and ETFs have ongoing annual fees called “expense ratios.” In the case of passive investment strategies, such fees are usually smaller than for active investment strategies, as passive strategies are less work and resources to implement. In addition, mutual funds may also have 12b-1 fees, which are used to pay for the funds’ marketing and distribution expenses. Also, some mutual funds may require you to pay a sales commission known as a “load.” ETFs do not have 12b-1 fees or sales loads.

Trading - Mutual funds are bought directly from the fund company that issues them. And when you want to liquidate some or all of your mutual fund holding, you directly redeem it from the fund company. ETFs trade like stocks, on a stock exchange, through a broker.

Valuation – Mutual funds are priced only once a day - at the close of the day - when the fund’s Net Asset Value, or NAV, is calculated. A mutual fund’s NAV is simply its prorated share of the fund’s total assets minus its total liabilities. ETFs are priced throughout the trading day and their prices are determined by the market’s supply and demand between buyers and sellers.

Taxation – Mutual funds often pass through capital gains each year from positions sold within the fund. Even if you own the fund the entire year without selling any of it, you still may involuntarily get some capital gains on which you’ll have to pay tax, if you hold the fund in a normal taxable brokerage account. ETFs rarely pass through capital gains, which makes them more tax-efficient if held inside a normal brokerage account.

For more information, watch my recent YouTube video, The Differences Between Mutual Funds and ETFs.