The Difference Between An ETF And A Mutual Fund: Key Things To Know (2024)

Exchange traded fund, mutual fund — they're all the same, right? Not so much. If you're building your investment portfolio and wondering about the difference between an ETF and a mutual fund, take a look at this primer.

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Mutual funds remain a titan, in terms of collective holdings. Over 44% of U.S. households — 56.2 million — owned shares of mutual funds as of mid-2017, according to ICI Research Perspective. But ETFs have become wildly popular in recent years with the younger set.

A 2018 Schwab study pegs ETFs as the "investment vehicle of choice for 91% of millennial investors," with those 20- and 30-somethings stuffing their portfolios with them. In fact, 56% of millennial investors have ousted individual securities from their trading lives in favor of ETFs, which now account for 42% of millennial stock portfolios, according to the survey.

"Within a decade, we've seen ETFs grow to the point where investors now see them as a foundational investment vehicle," said Schwab ETF & Mutual Fund Platforms VP Heather Fischer in a press release. "While this sentiment is particularly pronounced among millennial investors, it is reflected strongly across generations and genders."

So what is the major difference between an ETF and a mutual fund, and how does that impact your investments? There are a number of variations, some notable, some more subtle.

What Is An ETF?

ETF stands for "exchange-traded fund," which is a collection of stocks, bonds and other assets like commodities and futures.

ETFs have their own ticker symbols and trade like individual stocks. Many have investing themes, like marijuana stocks, Brazilian stocks and gold stocks.

An ETF is "more like a stock trade on an exchange in real time," says Michael Iachini, VP and head of manager research for Charles Schwab Investment Advisory.

What Is A Mutual Fund?

A mutual fund is similar in structure, but different in the way it is traded. Investors' purchases and sales of mutual funds are executed once a day after the market has closed at a price.

That price, or net asset value, is calculated by the total assets divided by the number of shares minus expenses.

What's The Difference Between An ETF And A Mutual Fund?

ETFs are traded more like stocks

You can trade an ETF at any time during the trading session, just like a stock, allowing you to take advantage of price fluctuations throughout the day. With mutual funds, "you can tell your broker (or fund company) any time you want, but nothing happens until the end of the day," says Iachini.

You can also place limit orders with ETFs, he says, which means setting certain price points to either buy or sell the funds. That can't be done with mutual funds.

ETFs often have lower associated costs

Many ETFs track indexes — like the Dow, S&P 500, Nasdaq and smaller indexes — which make managing them an inexpensive endeavor.

"The investment manager of the fund doesn't have to hire an expensive team of analysts or (do) in-depth data crunching to predict which stocks are going to go up or down in value," says Iachini. "They just have to track an index well. Which still requires professionalism, but doesn't require the same expensive research infrastructure that an active fund does."

But actively managed mutual funds — of which there are a lot— require all those elements. However, if you're interested in index investing, there are plenty of passively managed mutual funds that accomplish that.

Some fund providers even offer similarly priced ETF and mutual fund versions of index funds, adds Iachini, though there may be extra costs depending on which share class of a mutual fund you purchase.

ETFs sometimes involve trading commissions

Both ETFs and mutual funds charge expense ratios to cover operating costs.

Additionally, the brokerages that sell ETFs can also charge trading commissions, since the funds are bought and sold like stocks. Most major brokerages, however, offer a selection of commission-free ETFs.

Be aware that mutual funds can come with "loads" (read: sales fees) of their own. But there are plenty on no-load mutual funds available from brokerages.

And keep in mind that when buying ETFs, there's also the bid-ask spread, similar to a stock.

"That means if you're going to buy shares of an ETF, you're going to be buying them from someone else who owns them, and that person who owns them is usually the market maker," says Iachini. "Their whole business is saying, 'I'm willing to sell shares of this fund at a certain price that's a little bit high, and I'm willing to buy shares of this fund at a certain price that's a little bit lower,' and the gap between those is how that market maker makes their money. That's the bid-ask spread."

In other words, individual investors are forced to buy at the higher ask price and sell at the lower bid price.It's the "implicit cost" of trading stocks or ETFs that doesn't apply to mutual funds, he says.

ETFs are generally more tax efficient than mutual funds

Another key difference between ETFs and mutual funds lies in the tax savings of the two.

"ETFs have a reputation for being very tax efficient. That reputation is well deserved," says Iachini.

An index-tracking ETF has fewer taxable events than an actively managed fund— namely, capital gains distributions. Essentially, Iachini explains, when mutual fund managers sell stock for a profit, those realized capital gains are passed on to investors, which they then owe taxes on.

That can be frustrating for investors who purchased a particular mutual fund right before December, when those distributions are typically made, he says.

Still, a passive mutual fund is less likely to be traded than their actively managed counterparts, which translates to few capital gains, and therefore fewer capital gains taxes.

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