ETFs vs. Mutual Funds: A Comparison of Two Pooled Funds

As business magnate Warren Buffett said, "Diversification is the only free lunch in investing." Portfolio diversification refers to investing in a mix of assets to distribute risk. But diversification can be difficult to achieve without buying a significant number of assets.

Both exchange-traded funds (ETFs) and mutual funds provide investors with diversification benefits, though they have a few fundamental differences in structure, pricing and taxation. Both products use pooled funds to buy a bundle of assets. Understanding the nuances between ETFs and mutual funds can help you learn to invest like a pro.

A Brief History of ETFs and Mutual Funds

ETFs and mutual funds originated from the development of securitization in the 17th century. Securitization enables investors to pool funds to buy a group of assets and then each own a security or share of the collective investments.

Mutual funds are one of the oldest forms of pooled investing and represent an actively managed investment portfolio, usually tailored to a specific investment strategy. In the second half of the 18th century, mutual funds were created in The Netherlands as a means of offering smaller investors the opportunity to diversify.

America’s first mutual fund was created in 1924 and still exists today. As mutual funds proliferated, the government passed the Investment Company Act of 1940 to regulate investment companies like mutual funds and require them to register with the Securities and Exchange Commission (SEC).  

The ETF is another innovative product first listed by State Street in January 1993 as an S&P 500 index tracker. ETFs quickly gained interest for their convenience and liquidity because they can be traded on stock exchanges like traditional stocks. Many types of ETFs came on the market, such as sector ETFs, international ETFs and ETFs with complex strategies or adding leverage. ETFs have now grown to over $6 trillion in assets under management.

Similarities Between the Pooled Funds

ETFs and mutual funds are both pooled funds that offer investors access to a diversified portfolio that can include stocks, bonds or other investments. These pooled funds can invest in a variety of asset classes and niche markets, which give investors broader market exposure.

Both investment vehicles are regulated by the SEC, which requires public disclosure for investor protection.

Retail and institutional investors benefit from the convenience of ETFs and mutual funds. They can first select desired strategies and then choose the ETF or mutual fund that expresses the strategy.

6 Major Differences Between ETFs and Mutual Funds

ETFs and mutual funds have a few notable differences to consider when deciding which investment is best for you:

Pooled fund management

One of the main differences between ETFs and mutual funds is how they are managed. ETFs track the performance of a specific index or market and are typically passively managed. ETF providers use computer algorithms to buy and sell securities to match the underlying index automatically.

On the other hand, mutual funds are generally actively managed, which means that a professional fund manager selects the securities included in the fund. The fund manager will decide what to buy and sell based on their analysis of the market and individual securities.

Purchase and redemption processes

Another difference between ETFs and mutual funds is the way they are bought and sold. ETFs are traded on stock exchanges, just like individual stocks. This means that investors can buy and sell ETFs throughout the day at prices that are based on supply and demand.

Mutual funds, on the other hand, are not traded on an exchange. Instead, they are bought and sold directly through the mutual fund company or through a broker. The price of a mutual fund is typically determined at the end of the trading day based on the net asset value (NAV) of the underlying securities.

Pricing

Because ETFs are traded on an exchange, their prices can fluctuate throughout the day based on supply and demand. This price volatility means that the price of an ETF may be different from its NAV, which is the value of the underlying securities in the fund.

In contrast, mutual funds are typically priced at their NAV, meaning that the price of a mutual fund is based on the value of the underlying securities rather than supply and demand. Additionally, investors who purchase on the same day generally receive the same price since mutual fund orders are executed once per day.

Pooled investment costs

ETFs usually have lower expense ratios than mutual funds because they typically require less management . In general, the  average expense ratio of ETFs ranges from 0.1% to 0.75% depending on the fund, while the expense ratio for mutual funds is between 0.5% to 1%. ETFs also typically have lower trading costs because they are bought and sold like stocks.

Investors can purchase mutual funds without trading commissions, but they have a load, or a sales charge, that you must pay when you buy or sell shares. This sales charge can range from 1% to 8.5%.

Fees and minimum investments

ETFs do not have minimum investment requirements because they can be bought and sold like stocks. You may pay commissions for trading ETFs, while mutual funds might not carry commissions but could have other operating expenses and fees.

Mutual funds typically come with minimum investment requirements, which are a flat dollar amount. You can typically buy them in fractional shares or fixed dollar amounts.

Taxation

ETFs can be more tax efficient than mutual funds because investments generate fewer taxable events. Investors are taxed when they sell their ETF shares, rather than during the holding period. ETFs are taxed when an investor sells the ETF shares, which generates fewer taxable events because ETFs usually have lower turnover.

In contrast, mutual funds distribute capital gains when they are held, triggered when the fund manager sells securities within the fund that generate a profit. Your capital gains distributions are then subject to taxation, even before you sell the position.

Which of the Pooled Investments Should an Investor Choose?

Choosing between an ETF and a mutual fund will depend on many factors such as: investment strategy, goals, risk tolerance and time horizon.

Active investor

ETFs may be a worth exploring choice for different types of investors including active investors who want to trade the market, have a higher risk tolerance and are tax-sensitive. ETFs can provide access to a variety of investments, such as stocks, commodities and bonds, with a single purchase. They also generally have lower expenses and commissions than mutual funds, making them more cost-effective for short-term trading. Additionally, ETFs are typically more tax efficient than mutual funds because they tend to generate fewer capital gains distributions.

Long-term investor

Long-term investors who, among other types, don't have the time to watch the market closely and have a low tolerance for risk might want to consider mutual funds. Mutual funds also provide investors with more investment variety. You can access a broader range of mutual funds designed for diverse investment strategies, risk tolerance levels and asset types.

Choose the Best Product for Your Goals

Both ETFs and mutual fund investments offer diversification for your chosen investment strategy. Choosing between them depends on how much you want to invest, your desired levels of control and risk tolerance and your short-term and long-term investment goals. Research and explore your investment options on Moomoo with the support of advanced analytical tools and real-time data.

Before investing in an ETF, you should read both its summary prospectus and its full prospectus, which provide detailed information on the ETF’s investment objective, principal investment strategies, risks, costs, and historical performance (if any). Diversification is an investment strategy that can help manage risk within your portfolio, but it does not guarantee profits or protect against loss in declining markets.

This article is for informational and educational use only and is not a recommendation or endorsement of any particular investment or investment strategy. Investment information provided in this content is general in nature, strictly for illustrative purposes, and may not be appropriate for all investors. Investing involves risk regardless of the strategy selected and past performance does not indicate or guarantee future results.