Both ETFs and mutual funds are professionally managed, pooled investment vehicles. They offer investors broad market exposure at a cost that’s generally lower than that of buying individual securities. But while ETFs and mutual funds share some characteristics, they also have notable differences in the way that they’re structured and traded.
What is an ETF?
An exchange-traded fund (ETF) is a pooled form of investment that is designed to replicate, or track, an index, sector, or commodity. An ETF that is structured to track an index is also known as an index fund. ETFs trade like stocks: Investors buy and sell shares of ETFs on a stock exchange in real time.
ETFs can be structured to track almost anything, from a commodity to an industry sector. Common types of ETFs include:
- Industry sector ETFs : An industry sector ETF will give you exposure to stocks and securities in specific sectors. For example, the Vanguard Health Care ETF attempts to track the U.S. health-care industry.
- Bond ETFs: These track bonds. An example of a bond ETF is the iShares Core U.S. Aggregate Bond ETF, which gives investors exposure to investment grade (meaning higher quality) U.S bonds based on an index compiled by Bloomberg.
- Commodity ETFs: ETFs of this type track individual or baskets of commodities. They cover a broad array of commodities, including precious metals, oil, livestock, and just about any other physical commodity you can think of. An example is the SPDR Gold Shares ETF, which is physically backed by gold.
- Currency ETFs: These ETFs track the relative value of foreign exchange (forex) or currencies. The Invesco CurrencyShares Euro Trust, for example, tracks the euro versus the U.S. dollar. It gains when the euro strengthens versus the dollar and declines when the dollar rises.
- Inverse ETFs: Also known as a “Short ETF” or a “Bear ETF,” inverse ETFs are meant to perform inversely to the index they track. For example, the Direxion Daily S&P 500 Bear 1X Shares tracks the S&P 500 Index with opposite but equal returns. So when the S&P 500 falls by 4%, this ETF would be expected to rise about that percentage.
What is a mutual fund?
A mutual fund pools resources of multiple investors to buy a bundle of stocks and other securities like bonds. When you buy into a mutual fund, you’re not buying those securities directly, but shares of the fund that buy and sell those securities on your behalf. Professional fund managers oversee mutual funds on investors’ behalf. Investors can buy mutual funds from a mutual fund company or through a brokerage firm.
The price of a mutual fund, which determines what you pay for its shares, is called its net asset value (NAV). To calculate a fund’s NAV, you divide the total value of all the securities in its portfolio by the number of shares owned by shareholders, institutional investors, and company stakeholders, among others. As opposed to stock prices, which fluctuate with the market, the NAV is set at the end of each trading day.
Mutual funds generally come with maintenance fees, and some charge fees like sales commissions for funds bought and sold through a broker.
Types of mutual funds:
- Stock funds. Stock mutual funds, or equity funds, invest in a group of stocks. The Fidelity Growth & Income Portfolio, for example, holds 193 different stocks and tries to achieve higher dividend and earnings growth than the S&P 500.
- Bond funds. Bond funds invest in bonds. For example, the PIMCO Long-Term Credit Bond Fund invests in a mix of investment grade and high-yield, or junk, bonds.
- Balanced funds. Balanced mutual funds invest in a mix of securities, from stocks and bonds to certificates of deposit (CDs). They aim to maximize value while reducing risk by diversifying in a number of assets. The BlackRock 80/20 Target Allocation Fund, for instance, holds 80% of its assets in stocks and 20% in bonds. Other funds offer different blends, depending on an investor’s risk tolerance.
- Money market funds. Money market funds have lower risk than other mutual funds and purchase short-term debt issued by the government, banks, or corporations. For example, the American Funds U.S. Government Money Market Fund, invests in government-issued debt and related securities.
- Target-date funds. Target-date funds account for your age, investing aggressively when you’re younger, and theoretically can take on more risk, then making safer bets on bonds and the like as you near retirement. The T. Rowe Price Retirement 2025 Fund, for example, is designed for an investor who plans to retire at age 65 in 2025.
Similarities between ETFs and mutual funds
ETFs and mutual funds share a number of characteristics, pooling the money they receive from shareholders to invest in a mix of securities. Both can offer:
- Diversification. Diversification is a strategy meant to mitigate risk by spreading investments across different types of securities, asset classes, or geographic regions.
- Active and passive options. With actively managed ETFs and mutual funds, professional fund managers oversee the fund’s portfolio. They buy and sell securities in the fund with the goal of improving performance. Passively managed ETFs and mutual funds aim to replicate the moves of a market index like the S&P 500 and don’t require an investor’s oversight.
Differences between ETFs and mutual funds
The main differences between the two lie in how they trade on securities markets and the tax liabilities they can create for investors.
- Trading frequency and real time pricing: ETFs trade throughout the day on stock exchanges whereas mutual funds only trade once per day as the exchanges close. This gives investors more control over the price they pay for ETFs.
- Minimum purchases: Mutual funds often come with minimum purchasing requirements; for example, a minimum investment of $5,000. ETFs do not have such requirements. The minimum needed to invest in an ETF is the cost of a share.
- Taxes: ETFs can be more “tax-efficient” for investors, meaning they tend to incur fewer taxes. This is because they tend to have fewer taxable events than mutual funds. But note that an investor’s gains from ETFs and mutual funds are always subject to capital gains taxes.
The bottom line
Mutual funds and ETFs offer many of the same features: They pool money from shareholders to invest in securities, commodities, currencies or bonds, making it easier for investors to diversify without the cost and effort needed to research and buy individual assets.
But there are differences as well, mainly having to do with how often they trade on securities markets and the tax liabilities they create.