Key Difference Between ETFs & Mutual Funds

In this article, we break down the differences between two types of investment vehicles - ETF vs mutual fund. We ask what is an ETF? What are mutual funds? Should you be looking to invest in ETFs or mutual funds, or neither?

In many ways, ETFs and mutual funds are similar instruments. They both involve a pool of money from investors. They both can gain access to a range of different asset classes in global markets. They are also both managed by a fund manager for a fee. So, what is the difference between an ETF vs mutual fund, and which is best for you?

What is an ETF?

Exchange Traded Funds (ETFs) emerged in the 1990s. They were created as a low-cost and diversified solution for investors, with funds being passively managed and tracking popular major global indices, such as the S&P 500 or Nasdaq 100.

ETFs opened up a whole new world to investors, unlocking access to asset classes such as precious metals, bonds, and currencies, making previously cordoned-off areas of capital markets now available to investors. 

It was some time before they became a popular investment instrument. In the 2000s there was a major increase in the sheer amount of ETFs available and used in the mainstream by both retail and institutional investors to access broad market indexes. In 2023, assets invested in ETFs globally soared to $11 trillion, as reported by Track Insights.

Types of ETFs

Underlying securities in an ETF could include stocks, bonds, commodities, or a mix:

●    Equity ETFs are made up of stocks and can offer access to many companies simultaneously.
●    Bond ETFs are made up of fixed-income assets and pay out interest from the bonds within the portfolio. 
●    Commodity ETFs invest in raw materials and products such as precious metals like gold, natural resources like oil, and agricultural products like coffee. 
●    Sector and industry ETFs allow investors to access specific parts of the economy. e.g. tech or healthcare.
●    International ETFs allow investors to access different economies, whether that’s global exposure or for specific regions.
●    Thematic ETFs group together investments exposed to a trend that sits across sectors and geographies,  such as reshoring or obesity. e.g. the world's first GLP-1 and weight loss ETF. 
●    Inverse ETFs aim to deliver the opposite return of a specific index or stock.
●    Leveraged ETFs deliver magnified returns on your original investment.

The Advantages of ETFs

ETFs are innovative investment products, attracting hundreds of billions of net inflows each year. According to Track Insight, the assets invested in ETFs in the Americas by the end of 2023 surpassed $8.4 trillion, a staggering 25% rise year on year. 

The benefits of investing in ETFs include flexibility, diversification, low cost, tax efficiency, transparency, and accessibility. ETFs can be passive, i.e. tracking an index, or actively managed, having a fund manager doing the heavy lifting. 

●    Ability to buy and sell: Much like a stock, you can buy and sell ETFs throughout the day when markets are open. 
●    Diversification: ETFs contain a broad exposure to many different assets, improving its risk-adjusted returns.
●    Low cost: ETFs tend to have lower fees compared to other investment options. 
●    Transparency: Holdings are disclosed daily, providing clarity on what is in the fund. 
●    Accessibility: ETFs offer access to a full suite of asset classes across global markets via a brokerage account.
●    Tax efficiency: ETFs will generally generate less capital gains tax distributions than other investments.
●    Professionally managed: ETFs can be managed actively depending on investment objectives.

What are Mutual Funds?

Types of Mutual Funds

So, what is in a mutual fund? 

Mutual funds can contain different types of securities from equity, to fixed-income, to hybrid. They offer different benefits, so which one to invest in depends on your investment objectives. 

●    Equity Funds are primarily made up of stocks and can be further segmented into growth value, or blend funds.
●    Bond Funds contain fixed-income investment instruments such as bonds and government securities.  
●    Money Market Funds are for investors who want to hold their savings and invest short-term, with low risk and high liquidity.
●    Income Funds are set up to provide a steady income and are typically used for retirement investing.
●    Index Funds are set up to mirror the performance of a particular market index.
●    Balanced Funds are made up of stocks and bonds to gain exposure to both simultaneously.
●    Sector Funds allow access to specific parts of the economy, such as tech or healthcare.

The advantages of mutual funds

Mutual funds are a way for investors to gain exposure to a pool of stocks or bonds, sometimes segmented by market cap, sector, or industry. It is reported that in 2024 the US mutual funds industry holds over $34 trillion under management. 

The benefits of investing in mutual funds include professional management of the fund, diversification, and a variety of funds to choose from. 

Benefits include: 

●    Professional Management: Mutual funds are predominantly actively managed by fund managers who make decisions based on their market analysis and outlook, in line with the investment strategy.
●    Diversification: Mutual funds are set up to be diversified and spread across a range of asset classes to decrease risk. 
●    Variety: There are many types of funds, to cater to your risk appetite and investment goals.

Performance comparison between mutual funds and ETFs

The difference between an ETF vs mutual fund comes down to several factors. 

The most important determinent of return is the investment strategy. ETFs and mutual funds can be passively or actively managed. For the former, the performance of the index constituents and any deviation from the index (tracking error) will impact returns. For the latter, returns depend on the skill of the active manager in selecting securities.

For an identical strategy, ETFs will have a performance advantage over a mutual fund for three reasons. First, ETFs are much more tax efficient meaning after-tax returns are better for investors over the long run. Second, Mutual funds tend to have higher fees while ETFs have a single lower fee. Compounding means even small differences in fees can impact long-term returns. Finally, because ETFs are more liquid and don’t have load fees (fees charged when buying a mutual fund), establishing and exiting a position in an ETF can be cheaper, also helping performance. 

Tax considerations for ETFs and mutual funds

ETFs are more tax-efficient than mutual funds. Why?

When an investor tries to redeem from a mutual fund the manager of the fund must sell the underlying securities into cash to return to the investor. This can create tax for the fund which is borne by all the investors in the fund, not just those selling. 

When an investor tries to redeem from an ETF they can sell ETF units in the secondary market. This doesn’t involve the underlying holdings. If there is a lot of selling the primary market in ETFs facilitates the redemption of units in the ETF in exchange for the underlying securities. This means no cash actually changes hands which means no taxable event. 

Cost and expense ratios comparison between mutual funds and ETFs

What is the difference in the cost and expense ratio between an ETF vs mutual fund?

Funds such as mutual funds generally have a higher expense ratio because they are predominantly actively managed and also have a higher cost to run, and this cost is passed directly to investors. These costs could include but are not exclusive to operational and administrative fees. Expense ratios for mutual funds can typically range between 0.5% and 2%.

ETFs have one single fee that is transparent and clear to the investor and avoids the additional costs and expenses you get with a mutual fund. Expense ratios for ETFs can typically range between 0.05% and 0.75%.

What about buying and selling ETFs vs. mutual funds?

The clue is in the name - the funds are traded through a broker via an exchange. This is a relatively simple transaction with little cost involved apart from the brokerage fee. There are no other fees involved and it is just like buying a stock.

With a mutual fund, investors With a mutual fund, investors deal directly with the fund company. This happens once a day and can involve fees called load fees. These fees can happen when buying (front load) or selling (back load) and can be substantial.

Risk comparison between mutual funds and ETFs

When it comes to risk and risk management, how does it differ between an ETF vs mutual fund? 

Mutual funds can be low or high-risk, depending on the fund strategy and objective. It’s important to check the strategy and objective of these funds before investing if you want a lower-risk investment. Actively managed funds are also subject to the risk of the fund making bad investment decisions. This could lead an active fund to underperform vs the markets. 

ETFs can be active or passive. Similarly to mutual funds, actively managed ETFs are subject to the risk of the management of the fund. Passively managed ETFs are more subject to market risk at the will of the underlying index or asset class. 

There are other risks such as liquidity and tax implications. Mutual funds may face liquidity issues, only being redeemed once per day. ETFs generally have higher liquidity, traded throughout the day on the exchange. ETFs are tax efficient and reduce capital gains distributions, however, mutual funds often distribute capital gains tax annually, creating tax liabilities for investors.

Lock-in period comparison between mutual funds and ETFs

A “lock-in period” is the duration you must hold your investments, designed to encourage long-term investment. This affects liquidity for investors, as their money is locked in the fund.

Mutual funds may have a lock-in period, in which the investment cannot be redeemed or sold. The length of this period will vary from fund to fund, depending on the mutual fund scheme. For example, Equity Linked Savings Schemes (ELSS) typically have a 3-year lock-in period. This promotes long-term investing however restricts access to liquidity for investors.

However, ETFs don’t have a lock-in period and can be bought and sold at any time when the markets are open. This provides high liquidity and flexibility for their investments and makes ETFs attractive for investors who need immediate access to their funds. However, beware that high trading may result in higher brokerage fees and short-term capital gains for end investors.

Liquidity comparison between mutual funds and ETFs

ETFs offer high liquidity. They are traded on global stock exchanges and have continuous pricing throughout the trading day. You can buy and sell when the markets are open, as you wish. Much like equities, due to the accessibility and liquidity of ETFs, all types of users can apply them effectively in their investment portfolio, from hedge funds to retail investors. Therefore, you can hold a long or short position on the instrument, for any time scale you wish, making it possible to make a profit from the price going down as well as up.

How does this differ between an ETF vs mutual fund? Mutual funds are limited in this aspect, and can only be bought and sold once per day at their NAV price, affecting their liquidity and also their flexibility to be traded.

Exit load comparison between mutual funds and ETFs

Exit load refers to the fees imposed when redeeming their units from the fund for a specific period. They are more prevalent in active funds and are designed to discourage short-term trading and contribute towards the cost of managing the fund.

The period for which an exit load applies can be months or it can be years. For mutual funds, the exit load can typically range from 0.5% to 2%. This can affect the investor's returns if they need to withdraw the investment earlier than planned.

Much like trading stocks on the exchange, ETF investors buy and sell ETFs at the current price without incurring such fees. This makes ETFs a more attractive offering for investors, offering greater flexibility and higher liquidity. However, as previously mentioned, there can be trading costs such as brokerage commissions to be aware of when buying and selling EFT shares and this should be accounted for in the total cost of the investment. That aside, there is a clear winner between an ETF vs mutual fund regarding exit load.

Similarities between ETFs and mutual funds 

Now that we have explored both types of investment vehicles - ETF vs mutual fund - to understand the differences between them, we can explore the similarities.

• Diversification: Both instruments are well-diversified, reducing risk and investing in a wide range of securities.
• Passive/Active Management: ETFs and mutual funds are managed, however, one more than the other. Most ETFs are passively managed, while most mutual funds are actively managed. This active management includes analyzing and making changes to the fund, and selecting the securities.
• Net asset value (NAV): Both instruments have the NAVs calculated at the close of the markets each day.
• Wide range: There are many different types of both funds, offering a choice to suit your investment approach and risk appetite.

Why prefer ETF over mutual funds

When comparing an ETF vs mutual fund, it is clear to see why one would choose to invest in an ETF. The benefits of accessibility, flexibility, and liquidity, all at a low cost are unmatched by mutual funds.

However, there is another reason to opt for an ETF. In the past, the financial services industry has had a bad reputation for not being transparent, especially when it comes to what is actually in funds.

As per law, mutual funds have to disclose their portfolios quarterly. Hedge fund and institutional fund managers are the same. In between this, investors are left in the dark about any changes to the funds, or whether the funds are drifting from their original objectives which they signed up for.

ETFs are more transparent than any other investment instrument accessible to investors, disclosing their performance, investment strategy, and their holdings on a daily basis. This daily transparency means that investors can easily check in on their portfolio and make adjustments as they wish. This is regardless of whether the ETF is managed passively or actively.

ETF vs. mutual fund: which is better for you

Choosing between an ETF vs mutual fund is not an easy choice, however, there can be clear advantages for investors should the benefits align with your investment goals and objectives.

An ETF offers a low-cost and flexible investment, with added tax efficiencies. Traded on the exchange, they can be bought and sold through the day at market prices.

Mutual funds generally come at higher costs and can be bought and sold once per day at the NAV, rather than throughout the day, offering less trading flexibility than ETFs. As well as higher costs for the management of the fund, there are more capital gains tax distributions, and there may well be other costs including operational and administrative fees.

To summarize, when it comes to choosing an ETF vs mutual fund, the key advantages of an ETF over a mutual fund are that you can invest more freely and have constant access to your funds while keeping costs and fees low.

Conclusion

In this article, we have covered all bases comparing an ETF vs mutual fund. We have broken down the differences between an ETF and mutual fund, the advantages of each, and the similarities.

Both investments offer diversification into global markets and a wide range of types of asset classes to choose from to meet your investment goals and objectives. What type of investment vehicle you choose is ultimately based on your goals and objectives, however, doing your research before into the nuances of different instruments is key.

FAQ

Is it better to invest in ETFs or mutual funds?

It depends on the desired investment goals. ETFs are generally lower cost, more flexible, and more tax efficient. If you would like flexibility, high liquidity, and to avoid high costs and capital gains tax, then ETFs are likely to be more appropriate for you.

What are the 3 potential advantages of owning an ETF over a mutual fund?

Three advantages of owning an ETF over a mutual fund include:

• Higher liquidity: You can buy and sell at any time.
• Low cost: ETFs have a single transparent fee and no hidden charges.
• Lower taxes: ETFs generally generate lower capital gains tax distributions.

Are ETFs more cost-effective than mutual funds?

When comparing an ETF vs mutual fund, ETFs have potentially lower expense ratios than mutual funds. Mutual funds typically have higher management and operational costs and fees.

Are ETFs more tax-efficient than mutual funds?

ETFs are more tax-efficient than mutual funds as redemptions from funds happen in-kind shielding fund investors from the associated capital gains.

Why would anyone buy mutual funds over ETFs?

There may be a specific type of mutual fund that is appealing to an individual based on their investment strategy. However, always do research into the fund and the costs and fees before investing as there might be a similar investment with lower costs.

Is an ETF a riskier investment than a mutual fund?

Risk in an investment is a function of the portfolio and investment strategy. The same types of investment strategies can be housed in an ETF or a mutual fund. For an identical investment strategy, ETFs can be seen as marginally less risky because they offer more transparency, liquidity, and lower taxes.

What are the risks of investing in an ETF?

Investing involves risks and these depend on what the investment strategy of a particular ETF is. Read the prospectus and fund manager website carefully. Do your research to assess whether the ETF fits in your portfolio.