One of the most common questions new investors face is whether to invest in exchange-traded funds (ETFs) or mutual funds. Both are pooled investment vehicles that allow you to own a diversified basket of stocks, bonds, or other assets with a single purchase. Both can track the same indexes and hold the same underlying securities. Yet there are meaningful differences in how they trade, how they are taxed, and how they fit into different investment strategies. Understanding these differences will help you make the right choice for your specific situation.
How ETFs Work
An exchange-traded fund trades on a stock exchange just like an individual stock. You can buy and sell shares throughout the trading day at market prices, which fluctuate based on supply and demand. ETFs typically track a specific index โ such as the S&P 500, the total bond market, or a sector like technology or healthcare โ and their prices move in real time as the underlying assets change in value.
The most popular ETFs include the SPDR S&P 500 ETF (SPY), the Vanguard Total Stock Market ETF (VTI), the Invesco QQQ Trust (QQQ) tracking the Nasdaq-100, and the Vanguard Total Bond Market ETF (BND). ETFs have become enormously popular because of their low expense ratios, tax efficiency, and flexibility.
How Mutual Funds Work
A mutual fund pools money from many investors to purchase a portfolio of securities managed by a professional fund manager. Unlike ETFs, mutual funds trade only once per day, after the market closes, at the fund's net asset value (NAV). When you place an order to buy or sell mutual fund shares, the transaction executes at the end-of-day NAV price, regardless of when during the day you placed the order.
Mutual funds come in two main varieties: actively managed funds, where a professional manager selects investments in an attempt to outperform a benchmark index, and passively managed index funds, which simply track an index. Well-known mutual fund families include Vanguard, Fidelity, Schwab, and T. Rowe Price.
Key Differences: Costs
Expense ratios are the ongoing fees charged by the fund, expressed as a percentage of your investment. Both ETFs and index mutual funds typically have very low expense ratios โ often 0.03% to 0.20% for broad market funds. Actively managed mutual funds, however, charge significantly more, averaging around 0.50% to 1.50% per year. Over decades of investing, even a small difference in expense ratios can compound into tens of thousands of dollars in lost returns.
ETFs generally do not have minimum investment requirements beyond the price of a single share (though many brokerages now offer fractional shares), while some mutual funds require minimum initial investments of $1,000 to $3,000 or more. Transaction costs have largely been eliminated at major brokerages for both ETFs and their own proprietary mutual funds.
Key Differences: Tax Efficiency
ETFs are generally more tax-efficient than mutual funds due to their unique creation and redemption mechanism. When large investors redeem ETF shares, the fund can deliver the underlying securities directly rather than selling them on the open market, avoiding capital gains distributions to remaining shareholders. Mutual funds, by contrast, must sell securities to meet redemptions, potentially triggering taxable capital gains that are distributed to all shareholders, even those who did not sell.
This tax advantage makes ETFs particularly attractive for taxable brokerage accounts. In tax-advantaged accounts like 401(k)s and IRAs, the tax efficiency difference is irrelevant since you are not paying taxes on gains within the account.
Key Differences: Trading Flexibility
ETFs offer intraday trading, limit orders, stop-loss orders, and the ability to short sell โ features that are important for active traders but largely irrelevant for long-term buy-and-hold investors. Mutual funds' once-daily trading is actually an advantage for investors who want to avoid the temptation of intraday trading, since the simplicity of end-of-day pricing removes the possibility of impulsive buy-sell decisions driven by short-term market movements.
Which Should You Choose?
For most long-term investors, the choice between ETFs and index mutual funds is less important than simply choosing low-cost, broadly diversified funds and investing consistently. If you are investing in a taxable account, ETFs may have a slight edge due to tax efficiency. If you are investing in a 401(k), you will likely use whatever mutual funds your plan offers. If you prefer automatic investing with fixed dollar amounts on a schedule, mutual funds are slightly more convenient since you can invest exact dollar amounts rather than needing to buy whole shares.
The worst choice is no choice at all โ the drag of keeping money in cash while debating ETFs versus mutual funds costs far more than any difference between the two. Pick one, start investing, and focus on the factors that truly drive long-term returns: your savings rate, your asset allocation, and the decades of compound growth ahead of you.
The best fund is the one you will actually invest in consistently. Whether it is an ETF or a mutual fund matters far less than whether you are investing at all.
Disclaimer: This article is for educational purposes only and does not constitute financial advice. Read our full disclaimer here.