ETF vs. Mutual Funds: The Pros and Cons

Investing in stocks and having a diversified portfolio are two really common pieces of financial advice which, unfortunately, far too many people don't follow. Just 17% of Americans listed stocks as the best way to invest money they won't need for a while, compared with 30% who cited real estate and 23% who preferred cash investments, according to a Bankrate study.

Historical financial data shows stocks are likely to perform better for you than both real estate and cash, but of course investing in stocks may seem more confusing than buying a building or keeping cash in the bank. The good news is, there are two easy ways to invest and diversify: mutual funds and exchange-traded funds (ETFs).

ETFs and mutual funds both involve pooling money that becomes part of a big fund invested in a mix of different assets. Depending upon the mutual fund or ETF you buy, you can gain exposure to a broad mix of different assets with just a single fund purchase, making it easy to diversify and reducing risk compared with purchasing shares in a single company.

While ETFs and mutual funds have a lot in common, there are important differences between them that you should understand when you decide which investment is right for you.

Mutual funds vs. ETFs: Which are better?

When you're choosing between mutual funds and ETFs, here are a few key pros and cons that can help:

  • ETFs offer more trading flexibility: ETFs are traded like stocks. They're priced based on what investors think the market value is and you can buy and sell shares throughout the day. Mutual funds, however, can only be purchased or sold at the end of the trading day after the market closes and their price is based on Net Asset Value (NAV) -- the value of fund assets minus liabilities divided by the number of shares.
  • ETFs provide more transparency: ETFs typically disclose holdings daily. Actively managed mutual funds typically disclose their holdings on a quarterly or semi-annual basis.
  • ETFs are more tax efficient than mutual funds: Both ETFs and mutual funds are treated the same by the IRS in that investors pay capital gains taxes and taxes on dividend income. However, there are generally fewer taxable events in ETFs, which means tax liability will typically be lower. There are fewer taxable events because while mutual funds often must sell securities when shares are redeemed, ETFs are simply traded between investors and no underlying assets must be sold just because shares of the ETF are sold.
  • ETFs often have lower fees and expenses: ETF expense ratios are typically lower than mutual fund fees. In 2016, the average expense ratio of index ETFs was just 0.23% compared with a 0.82% average expense ratio of actively managed mutual funds and a 0.27% expense ratio for index equity mutual funds, according to Investment Company Institute. Many mutual funds include a variety of fees in their expense ratio, including fees to cover marketing and distribution costs.
  • ETFs often require lower minimum investments: Although there are some options for mutual funds that don't require you to invest a lot of money at once, many mutual funds have high initial investment requirements. This makes it a challenge to get started investing in a mutual fund if you don't have a lot of money saved. ETFs allow you to buy as little as a single share, which means that you don't need a fortune to get in the market.
  • Mutual funds allow you to trade without paying commission: Because ETFs are traded like stocks, you typically must pay a commission to buy and sell them. There are some commission-free ETFs available, but they may have higher expense ratios to recoup money lost from being commission-free. Mutual funds, by contrast, do not charge commission, although front-end or back-end loads paid when buying or selling can work similarly to a commission. There are, however, many no-load mutual funds that can be bought and sold with no broker commissions. Investors who plan frequent transactions, such as investors using dollar-cost averaging, may be better off with a mutual fund that does not charge a broker commission for each trade.
  • Mutual funds are more likely to be actively managed: Most ETFS are index funds, which track market indexes. While there are some actively managed ETFs, these tend to have higher prices. While some mutual funds are passive index funds, there are far more actively managed mutual funds than actively managed ETFs. With an actively managed mutual fund, a fund manager makes choices about how to allocate fund assets as opposed to assets being purchased simply to track an index. Active management can be a good thing if the fund manager is talented and is able to outperform the market. However, not all fund managers are good ones -- and you'll still likely pay higher costs for a poorly managed mutual fund than for passively managed ETFs.

Are ETFs or mutual funds right for you?

Both ETFS and mutual funds provide an easy way to invest in stocks and build a diversified investment portfolio. Ultimately, you'll need to consider a variety of factors including your tax strategy, the amount of money available to invest, and your overall investment strategy in order to determine which option is right for you.

By doing a little research to select either a good ETF or mutual fund, you'll usually end up better off over time than if you'd simply left your money in cash or bought real estate -- so don't be afraid to get into the market with a fund that is right for you.

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