What’s the Difference Between an ETF and a Mutual Fund?

exchange traded fundAs my husband and I were driving the other day I was telling him about a recent investment I had made in our Vanguard brokerage account. I told him I had purchased some more shares of one of my favorite Vanguard ETFs. His response was “Oh, that’s great.” Then after a pause he asked, “So what is the difference between an ETF and a mutual fund?” As I answered his question it occurred to me that he’s probably not the only one to be confused by the two. So I thanked him for helping me come up with my next post topic!

Mutual funds and exchange traded funds (ETFs) are similar as both are comprised of a group of securities which make up the fund. Because of this grouping, an investor can purchase shares of a mutual fund or ETF and gain broad exposure to a market index or sector. This can be an efficient way to diversify an investment portfolio. Without these funds, individual investors would have to buy hundreds or even thousands of different securities to achieve this diversification.

Even though mutual funds and ETFs are similar, there are some key differences to be aware of.

Fees and Expenses

One big difference between ETFs and mutual funds is the expenses paid by the investor. Expense ratios for ETFs are generally lower than those for mutual funds. One reason for this is that ETFs tend to be passively managed, meaning they are set up to replicate a certain index like the S&P500. Many mutual funds on the other hand, are actively managed meaning they seek to outperform the index. This increases the operating expenses as the mutual fund company has to pay the fund’s active managers and this expense is passed along to the investor. In addition to operating expenses, mutual funds can often have other types of fees including front- or back-end loads which are commission or redemption charges as well as 12b-1 charges which is a fee that helps pay for the fund’s advertising, annual reports, prospectus, and commissions paid to brokers.

Even mutual funds that are not actively managed can have higher fees than ETFs. Take, for example, the comparison between Vanguard’s 500 Index Fund (VFINX) and the Vanguard S&P 500 ETF (VOO). These are both S&P 500 index funds with virtually identical composition. However the total expenses for the mutual fund are 0.17% as compared to 0.05% for its ETF counterpart. The breakdown is shown below (this information was taken from each respective fund prospectus).
 

 

Management Expenses

Other Expenses

Total Expenses

Mutual Fund (VFINX)

0.14%

0.03%

0.17%

ETF (VOO)

0.03%

0.02%

0.05%

Since ETFs are traded through a brokerage account, just like individual stocks, some brokerage firms charge the same commission per trade that would be applied to stock purchases. This fee can range from $5 to $10 or more per trade. However, more and more brokers have been discontinuing this fee for some ETFs making them even less expensive. For example, in 2010 Vanguard stopped charging the $7 brokerage fee for purchases of Vanguard ETFs.

Minimum Investment Requirements

The discussion of fees above leads to another difference between ETFs and mutual funds. Traditional mutual funds often have investment minimums that are required before you can invest in the fund. ETFs usually do not have such requirements. For example, the Vanguard mutual fund above has a minimum investment requirement of $3,000. This could be a steep requirement for an individual investor looking to get started with a taxable brokerage account. What if you don’t have $3,000 saved up to invest? What if you have $3,000 and don’t want to invest that entire amount at once but would rather average in by buying smaller amounts systematically over a certain period of time? ETFs allow you to do this. As long as you have enough to buy one share of the ETF, you can make an investment. Just be sure to check if there is in fact a brokerage fee associated with each transaction, as this could greatly reduce the cost advantages of trading ETFs.

Speaking of Trades

Another difference between ETFs and mutual funds is the way in which the shares are purchased. ETFs were designed so that they could be traded just like regular stocks. ETFs can be bought and sold at any point during the trading day, whereas the price (net asset value or NAV) of mutual funds is set only once at the end of the trading day. So, if you want to purchase shares of a traditional mutual fund, you won’t know the actual price per share that you will end up paying until the NAV is set at the end of the day. Because ETFs can be traded like stocks an investor is able to set limit orders or even sell ETFs short. To invest in an ETF you determine how many whole shares you want to buy, whereas with a mutual fund you choose the amount of money you want to invest and this is converted to the number of shares at the end of the day after the NAV is determined.

Which is Right For You?

These are some of the differences between ETFs and mutual funds that I have taken into consideration for my own portfolio. Obviously everyone needs to make the choice that works best for their own situation. I’d like to finish with a few more points to consider.

  • Since ETFs are generally designed to replicate a market index or a market sector, they are predominantly passively managed. This means that if you believe that an actively managed fund would provide you with better returns or would provide you with a more appropriate asset allocation, a mutual fund might work better.
  • To reduce the impact of fees, shop around to find a brokerage firm that offers commission free ETF trades. If you plan on making investments in a fund on a regular basis, a mutual fund with a higher expense ratio could actually be less expensive than an ETF with a lower expense ratio that has a per-trade commission.
  • Always check a fund’s prospectus before investing so you are aware of all fees as well as the fund’s composition and objectives.

Since I’m not looking to beat the market through active management, I choose ETFs over mutual funds in my taxable brokerage account so that I pay lower fees. As far as I know, ETFs are not yet offered in 401K type retirement plans. But Charles Schwab is working on that. This would be great as it would help reduce the fees you pay in your current plan.

Now it’s your turn. Tell me, readers, what are some other differences between ETFs and mutual funds? Do you have a preference of one over the other?

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27 Responses to What’s the Difference Between an ETF and a Mutual Fund?

  1. Mark Ross says:

    I think ETFs are better than mutual funds especially for traders. The fees charged by fund managers can really get out of hand, so investing on ETFs is the better option for some.

  2. That’s a good summary of ETFs. I saw that Khan Academy has a series of videos on mutual funds and ETFs that also does a great job explaining (in basic terms) what mutual funds and ETFs are.

    Three things I would add to the understanding of ETFs:
    -discount/premium to NAV
    -bid/ask spread, and
    -average volume

    You can lose out if you’re buying at a steep premium to NAV or selling at a discount to NAV. Finding out the NAV during the day versus the quoted price can be tricky. I think Fidelity has some tools to help but it might be only for account holders.

    The bid/ask spread can cost you money if it’s really wide. Limit orders can help, but you are theoretically spending half the bid/ask spread each time you buy an ETF.

    Which brings me to the last point. Liquidity is important because it can keep the bid/ask spread small. And higher liquidity means you are less likely to “move the market” by buying up all the cheapest lots at the ask price, then the next cheapest lots $0.01 more expensive, then the next lots another penny more expensive, etc. I think that’s called “market impact costs”.

    • Green Money Stream says:

      Thanks for the input, Justin. Those are all important considerations too. There are also some tax differences as well with mutual fund being less tax efficient in general. I wasn’t sure how much detail to go into and wanted to go over the differences that matter the most for me. Since I’m investing in index funds for the long term I’m less concerned about costs associated with the bid/ask spread and I feel the market will do a pretty good job in taking care of any price differential between the ETF and the NAV of the traditional fund. But it’s certainly a good idea to try to get the best price you can, everything else being equal. Thanks for the thoughtful comment.

  3. Thanks for sharing this explanation! You’ve piqued my curiosity about ETFs ever since you commented on my “Lower Broadway” post. I’m currently navigating the differences between index funds and ETFs to figure out what is best for me.

    • Green Money Stream says:

      I hope it helped a little. I think in general if you are investing in an index fund, an ETF is probably a lower cost alternative (just make sure to check for those brokerage fees).

  4. Kay,
    Vanguard’s ETF is the same expense ratios as their admiral mutual funds. A benefit of mutual funds is that you can buy fractional shares. If you have at least $2500 you should never have to pay for an ETF as Fidelity, Schwab, TD Ameritrade and Vanguard all offer free trades.

    • Green Money Stream says:

      Thanks Charles! That’s a great point. Yes, the admiral level is the same expense ratio which is nice. Although that requires a minimum investment of $10,000 which not everyone has when starting out. Do you feel there is an advantage at that level (with $10,000 invested, say) to choosing a mutual fund over ETF? I know there are tax differences but I didn’t think they were significant with index funds.

  5. SavvyJames says:

    Great topic. Like you, I am a fan of ETFs, in large part because of the lower fees. The importance of minimizing those fees cannot be overstated.

  6. Liz says:

    To be honest, when I first opened my taxable brokerage account I intended on investing in ETF’s but I actually invested in mutual index funds. Not a huge deal as they are still relatively inexpensive but have since invested in a few ETF’s. At the beginning, investing can be a little overwhelming. Luckily though those investments all seem to be doing well : ) great post.

    • Green Money Stream says:

      I completely agree about it being overwhelming. I like to think of myself as still “dipping my toes in”, but it’s a good way to learn. If the funds are similar, I would choose ETF. Even a small difference in expenses can add up to thousands of dollars in the long run.

  7. Very nice overview. I personally use mostly ETFs for my portfolio of almost all index funds. I like that many of the big brokerages allow you to trade commission-free, and there is no minimum to invest. One thing to keep an eye on with ETFs is the volume of trading. You just want to make sure you’re buying for NAV or very close to it. Most of the time its no issue, but worth checking if you’re looking at a new fund.

  8. Thanks for this, Kay – I learned a lot from this post, as we are just working to educate ourselves about investing right now.

  9. AverageJoe says:

    Isn’t it funny how discussions now become material for the blog? My understanding is that Schwab introduced the ETF 401k last week, but I could be wrong…..

    • Green Money Stream says:

      I know! I’m always thinking about material for the next post! Yes, I believe Schwab rolled it out last week, but it was a couple of years in the making. This will hopefully greatly reduce the fees paid in retirement accounts. Thanks for stopping by!

  10. Great breakdown here Kay. I have limited exposure to ETFs, but as my taxable accounts grow, I’ve been doing some more research. The free trade aspect is definitely appealing. To be honest, it’s an issue I need to devote more of my time towards looking into. But I’m looking forward to the day they are offered in 401(k) plans!

    • Green Money Stream says:

      Glad you enjoyed it Ryan. Well Schwab has rolled out the first 401K plan offering ETFs. I have to imagine others will follow suit.

  11. Poor Student says:

    I’m thinking of investing some money in trading but I have no idea the differences of things that we can invest on. Thanks for sharing, really helpful.

  12. Pingback: What Are Investment Fees Really Costing You? | Green Money StreamGreen Money Stream

  13. Andropolous says:

    Is there any tax difference between owning VFINX Admiral shares and VOO ?
    This question would apply to any pair of index-mutual-funds and a comparable index-ETFs, and would be relevant when the mutual fund overhead is comparable to the corresponding ETF overhead.

    • Green Money Stream says:

      That’s definitely a good question and could be a consideration when deciding between the two investments. I don’t know the answer but I suspect that the tax treatment would be comparable for an ETF and mutual fund with virtually identical composition.

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