Beginner investors face the same challenge right now: how do you start investing during a recession and where should you put your money? Even the most experienced investors grapple with that second question.
If this sounds like you, you might be wondering which is the better investment: ETFs or mutual funds. Both are sound options for new investors, but depending on your preference, you might find one more appealing than the other.
In this article, we’re going to explore ETFs and mutual funds to help you decide which is the right investment for you. We’ll take a look at some of their similarities and differences, and help you understand how each investment works and how they fit (or don’t fit) into your overall investing strategy.
ETF vs. mutual fund: how they’re similar
Exchange-traded funds (ETFs) and mutual funds share many similarities, which can make it difficult to decide which is the better investment option. Common features of ETFs and mutual funds include:
- Baskets of securities
- Professional management
- Lack of control for investors
- Costs despite performance
Baskets of securities
ETFs and mutual funds are essentially baskets of securities that allow investors to share in the interest of many securities in one fund without having to buy each individual security. Both allow investors to pool their money in a fund that consists of a variety of assets, including stocks, bonds, and commodities. In return, each investor gets a share in the investments in proportion to their holdings in the fund.
Most mutual funds and ETFs are managed by professional fund managers registered with the Securities and Exchange Commission. Depending on the type of fund and the overall goals and objectives of that fund, the fund manager will usually take either an active or passive investing approach.
You can invest in certain mutual funds or ETFs and receive immediate diversification in your portfolio. This might be ideal if you don’t want to pick and choose individual investments across a wide range of companies or industry sectors. For example, you can buy one share of the Vanguard 500 Index Fund (VFINX) or the SPDR S&P 500 ETF (SPY) and have immediate exposure to many of the stocks that make up the S&P 500.
Lack of control for investors
Although investors in ETFs and mutual funds can choose the funds they wish to invest in, they don’t have any control over the types of securities included in the fund’s portfolio.
Costs despite performance
As mentioned earlier, most ETFs and mutual funds are professionally managed by a fund manager. Investors who wish to own shares of a professionally-managed fund have to pay ongoing expenses to cover the costs of running the fund, including management fees, administrative fees, annual fees, and other expenses. The amount of these fees will vary from one fund to another, but in general, passive management costs less than active management. These fees exist regardless of how the fund performs.
ETF vs. mutual fund: how they’re different
Despite their many similarities, ETFs and mutual funds are not the same. They differ in several ways, which may make one investment a better option for you than the other. ETFs and mutual funds differ in the following ways:
- How shares are purchased
- Tax efficiency
- Investment minimums
- Management styles
- Trading frequency and convenience
- Automatic investments
How shares are purchased
Investors in mutual funds can buy shares either through a brokerage account or from the fund itself. ETF shares, on the other hand, are not sold directly to individual investors. ETFs sell blocks of shares known as creation units to authorized participants (usually large brokerage firms). These brokers then sell the ETF shares to individual investors on the open market.
ETFs are structured in a way that tends to result in fewer capital gains being distributed to investors, but ETFs are not immune to taxation. In both ETFs and mutual funds, distributions of passive income in the form of dividend payments trigger a capital gains tax, as does selling a share for more than you paid for it.
Shares of ETFs are generally redeemable in-kind, which provides some tax advantages over mutual funds. When an investor chooses to sell their shares, an authorized participant (broker) can exchange a block of shares with the ETF for a specified basket of securities. This prevents the ETF from having to sell securities to generate cash to repay the investor, which could otherwise result in taxable gains to the ETF. Normally, those capital gains would be passed to the investor.
ETFs also tend to be passively managed, which means they usually have lower turnover compared to mutual funds. In other words, most ETFs employ a buy-and-hold strategy instead of frequently trading to achieve a return established by the fund’s objectives. This also results in fewer capital gains taxes.
ETF shares are traded on the market at fluctuating prices, depending on the prices of the underlying securities in the fund and the overall interest in the fund itself. Although the share price could be a few hundred dollars, it's a relatively low entry point compared to many mutual funds. Although there are mutual funds with no minimums, many mutual funds require a minimum initial investment of between several hundred dollars to several thousand dollars.
Although ETFs and mutual funds are both professionally managed, ETFs typically have lower expense ratios than most mutual funds. An expense ratio is an ongoing cost an investor must pay to invest in the fund; this can include management fees, marketing fees, and other expenses. As long as an investor chooses a brokerage that doesn’t charge commission on trades, the ongoing cost of investing in ETFs is generally lower.
Mutual funds can be either actively or passively managed, whereas most ETFs are passively managed. Passively managed funds tend to be more affordable because they typically have lower expense ratios.
Trade frequency and convenience
Investors can buy and sell ETF shares at any time during an open market at the share’s current market price. Mutual fund investors can buy and sell shares once per trading day at the fund’s NAV or net asset value. A fund’s NAV is the per-share value of the fund’s assets minus its liabilities. It’s usually calculated at the end of the day when the markets close.
Investors in mutual funds can set up automatic investments to passively grow their nest egg. This isn’t an option with ETFs.
Is an ETF a good investment for you?
ETFs give investors a convenient, low-cost way to invest in broad swathes of the market with just one fund. Their affordable entry point, low expense ratios, and the fact that many brokerages don’t charge commission on trades make ETFs an appealing investment for beginner investors who may not have a lot of money to invest.
ETFs offer a range of investment choices, from the global stock market to the broad U.S. market, to a single asset category such as individual commodities (agricultural goods, natural resources, precious metals) or industry sectors (energy, financials, real estate investing). Purchasing one ETF can give investors immediate diversification. Purchasing several ETFs across the different asset classes can give investors a fully diversified portfolio.
If you’re looking for a low-cost investment vehicle that can save you the trouble of picking and choosing each individual asset yourself, an ETF might be a good investment for you.
Is a mutual fund a good investment for you?
Diversification is also one of the greatest benefits of mutual funds. One mutual fund can give investors access to hundreds of individual stocks or bonds. Investors have access to a range of investment choices with mutual funds just as they do with ETFs.
Mutual funds may be ideal for investors who like the idea of investing in an actively managed fund. Although the expense ratio will be higher than what you’d see with an ETF, a mutual fund gives you access to professionals who devote their time researching and analyzing investment choices. If you don’t have the time or interest to do this yourself, this might be the right choice for you.
With a mutual fund, you can also set up automatic investments. This allows you to accumulate shares regularly by making automatic electronic transfers from a bank account or paycheck. Depending on the fund, you may be able to avoid or reduce minimum investment requirements by participating in automatic investments.
If you’re willing to pay a higher expense ratio to invest in a fund under active management, you might be better off with a mutual fund.
FAQs about mutual funds vs. ETFs
Are ETFs safer than mutual funds?
Mutual funds and ETFs are generally equally safe. Most ETFs and mutual funds are registered with the SEC and are primarily regulated by the same laws under the Investment Company Act of 1940. Any investment has its risks, and you can ultimately lose money on your investments — whether you invest in an ETF or a mutual fund.
Why should you choose an ETF over a mutual fund?
You might choose to invest in an ETF over a mutual fund if you’re primarily concerned with cost. ETFs don’t have a minimum investment, and their ongoing costs are typically lower than that of mutual funds. Investing in ETFs over mutual funds can also be more tax-efficient. An ETF is structured in a way that results in fewer and smaller capital gains. ETFs usually incur capital gains taxes only when you sell your shares, whereas mutual funds can incur capital gains taxes as the shares in the fund are traded throughout the span of the investment.
Do ETFs pay dividends?
ETFs that consist of dividend-paying securities will pay dividends to investors. This depends entirely on the securities that make up the ETF.
Are ETFs good for beginners?
ETFs are good for beginners for several reasons: they’re affordable, so investors don’t need a lot of money to get started investing in ETFs and they don’t cost much to hold onto; they can provide immediate diversification; and ETFs offer the trading simplicity of stocks.
Are mutual funds good for beginners?
Mutual funds can be good for beginners who prefer to have their portfolio actively managed by a professional fund manager. If the investor would rather passive management, index funds can also be a great place to begin building a portfolio. Index mutual funds provide tremendous diversification benefits at a low cost.
The bottom line on ETFs vs. mutual funds
ETFs and mutual funds both pool investors’ money to buy stocks, bonds, and other assets. Both give investors a way to passively invest in a fund that can offer immediate diversification without the hassle of purchasing individual securities.
Compared to mutual funds, ETFs tend to be the more affordable option. ETFs don’t require a minimum investment beyond the market price of the share, and ETF expense ratios are often much lower. Most brokers no longer charge commission fees on trades, which was an issue investors faced with buying and selling ETFs in the past. Some investment apps — such as Stash and Robinhood — even offer fractional shares, which allows you to invest in stocks and ETFs for as little as $1, regardless of the share price. This can be very beneficial for beginner investors.
However, the higher cost of a mutual fund gets you a professional fund manager who might seek a higher return compared to the market. With mutual funds, you can also set up automatic investments. This can be an easy way to grow your nest egg without having to remember to allocate money to your investment account each month.
Whether an ETF or mutual fund is a better option for you depends on your strategy. Compare the benefits and drawbacks of each type of investment, and see which will better help you reach your investing goals.
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