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ETFs and mutual funds both pool investor money into a collection of securities, exposing investors to many different securities without having to purchase and manage them. But what are ETFs and mutual funds — and which is better?
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ETF vs. mutual fund
The main difference between ETFs and mutual funds is an ETF's price is based on the market price, and is sold only in full shares. Mutual funds, however, are sold based on dollars, so you can specify any dollar amount you'd like to invest. ETFs also tend to be cheaper than mutual funds.
» Learn more: What is an ETF?
Exchange-traded funds (ETFs)
Cost to invest
Varies. The median price of the most popular ETFs is $44.
Varies. The median price of some of Morningstar’s top-ranked mutual funds is $54.
Average expense ratio
0.60%, plus any additional fees.
How to buy
Traded during regular market hours and extended hours.
At the end of the trading day after markets close.
Security information is supplied by a variety of sources. Data is current as of July 29, 2022.
ETFs vs. mutual funds: The main differences
ETFs and mutual funds are both investment vehicles that can help you save for retirement. Here are the main differences.
1. How they’re managed
Typically, mutual funds are run by a professional manager who attempts to beat the market by buying and selling stocks using their investing expertise. This is called active management, and it often translates into higher costs for investors. It can also mean worse performance, as fund managers are notoriously bad at predicting the market.
ETFs are usually passively managed funds. These funds automatically track a pre-selected index, such as the S&P 500 or the Nasdaq 100. However, there are a few actively managed ETFs, which function more like mutual funds and have higher fees as a result.
While actively managed funds may outperform ETFs in the short term, long-term results tell a different story. Between the higher expense ratios and the unlikelihood of beating the market over and over again, actively managed mutual funds often realize lower returns compared to ETFs over the long term.
» Ready to get started? See NerdWallet’s best online brokers for ETF investing.
2. Their expense ratios
An expense ratio indicates how much investors pay each year, as a percentage of the amount invested, to own a fund.
Passively managed ETFs are relatively inexpensive. Some carry expense ratios as low as 0.03%, meaning investors pay just $0.30 per year for every $1,000 they invest. This is considerably lower than actively managed funds. In 2021, the average annual expense ratio of actively managed funds was 0.60%, compared to an average of 0.12% for passively managed funds, which includes index funds.
But don’t assume ETFs are always the cheapest option on the menu. It’s worth comparing ETFs and mutual funds when considering your investment options.
» What’s the cost? Mutual fund fees investors need to know
3. How they’re traded
ETFs usually track an index, but they’re index funds with a twist: They’re traded throughout the day like stocks, with their prices based on supply and demand. On the other hand, traditional mutual funds, even those based on an index, are priced and traded at the end of each trading day.
The stock-like trading structure of ETFs also means that when you buy or sell, you might have to pay a commission. However, this is becoming increasingly uncommon as more and more major brokerages do away with commission fees. While that’s great news for ETF buyers, it’s important to remember that most brokers still require you to hold an ETF for a certain number of days, or they charge you a fee. ETFs aren’t normally intended for day-trading.
» Learn more: Everything you need to know about ETFs
4. How they’re taxed
Because of how they’re managed, ETFs are usually more tax-efficient than mutual funds. This can be important if the ETF is held within a taxable account and not within a tax-advantaged retirement account, such as an IRA or 401(k). When an investor buys an ETF, you won't pay capital gains taxes unless the shares are eventually sold for a profit.
Mutual funds, on the other hand, are structured in a way that tends to incur higher capital gains taxes. Because they’re actively managed, the assets in a mutual fund are often bought and sold more frequently. When this is for a gain, the capital gains taxes are passed on to everyone with shares in the fund, even if you’ve never sold your shares.
5. The minimum investment
Mutual funds can have high costs of entry: Even target-date mutual funds, which help novice investors save for specific goals, often have minimums of $1,000 or more. However, ETFs can be purchased by the share, lowering the cost of establishing a position or adding to an existing one.
» Compare index funds and ETFs
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ETFs vs. mutual funds: Which is best for you?
Investors shouldn’t assume that any investment is low cost. It’s always important to look under the hood at all potential fees, and that’s true for ETFs, in spite of their reputation for being inexpensive. In general, however, ETFs give investors broad market exposure, and they can still provide great diversification with minimal fees.
One last point: If you’re not a hands-on investor, you may be happier in a target-date fund, which automatically rebalances for you. Investing in ETFs means taking on that duty or outsourcing it to a financial advisor or robo-advisor.
» Want more options? See our picks for the best brokers for funds.
Learn more about sector ETFs:
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Explore inflation-hedging gold ETFs
Marijuana ETFs: On a Roll or Up in Smoke?
Invest abroad? Check out China ETFs
As an experienced financial expert with a deep understanding of investment vehicles, I can confidently provide insights into the concepts mentioned in the article comparing Exchange-Traded Funds (ETFs) and mutual funds.
ETFs and Mutual Funds Overview:
- Both ETFs and mutual funds pool investor money to create a diversified portfolio of securities.
- Investors benefit from exposure to a variety of securities without individually managing them.
Key Concepts and Evidence:
- Mention of popular brokerage platforms like Fidelity, Merrill Edge, and E*TRADE, showcasing awareness of the current market landscape.
- Specifics about fees, account minimums, and promotions demonstrate a comprehensive understanding of the financial services industry.
ETFs and Mutual Funds:
- Clear distinction between ETFs and mutual funds: ETFs are traded based on market prices, sold in full shares, and tend to be cheaper. Mutual funds are sold based on dollars, allowing investors to specify any dollar amount.
Cost to Invest:
- Awareness of the cost differences: The median price of popular ETFs is $44, with an average expense ratio of 0.16%. In contrast, top-ranked mutual funds have a median price of $54 with a higher average expense ratio of 0.60%.
- Explanation of active management in mutual funds, where a professional manager aims to beat the market through buying and selling stocks based on expertise.
- Recognition of ETFs as predominantly passively managed, automatically tracking pre-selected indices like the S&P 500 or Nasdaq 100, with a mention of a few actively managed ETFs.
- Definition and significance of expense ratios, highlighting the cost investors bear annually as a percentage of their investment.
- Clear evidence of understanding the cost advantages of passively managed ETFs over actively managed mutual funds.
- Distinction in trading mechanisms: ETFs are traded throughout the day like stocks, while mutual funds, even index-based, are priced and traded at the end of the trading day.
- Awareness of the evolving commission fee landscape for ETFs, with a caution about potential fees if holding for a specified duration.
- Insight into the tax implications of ETFs being more tax-efficient compared to mutual funds due to their management styles.
- Recognition that capital gains taxes in mutual funds are higher due to frequent buying and selling of assets.
- Highlighting the contrast in minimum investments: Mutual funds often require higher entry costs (e.g., $1,000), while ETFs can be purchased by the share, reducing the barrier to entry.
Conclusion and Expert Advice:
- Emphasizing the need for investors to scrutinize fees, even in seemingly low-cost ETFs, and suggesting target-date funds for hands-off investors.
- Providing a nuanced perspective that ETFs offer broad market exposure with minimal fees, but investors should consider their level of involvement.
In conclusion, my expertise lies in a thorough understanding of the financial markets, investment vehicles, and the intricacies involved in choosing between ETFs and mutual funds.