Mutual funds vs. exchange-traded funds (ETFs): What’s the difference?
Editorial staff, J.P. Morgan Wealth Management
- Both mutual funds and exchange-traded funds (ETFs) are investment vehicles that pool money from multiple parties to invest in diversified portfolios of securities and other assets.
- Mutual fund shares are traded only at the end of the trading day at the fund’s net asset value (NAV), while ETFs can be traded throughout the trading day at market prices.
- The in-kind redemption process for ETFs, which helps them avoid realizing capital gains, can be more tax-efficient than mutual funds.
- The right choice for you depends on your unique investment goals, strategy and preferences.
While handpicking individual investments like stocks and bonds is an investment strategy that plenty of people employ successfully, you may want to diversify your portfolio without managing every investment yourself. That’s where mutual funds and exchange-traded funds (ETFs) can come into play.
Both offer access to portfolios that will help spread an investment across a wide range of securities and assets.
But how do these tools differ, and which one may be more appropriate for your investment strategy? Here are some important things to know.
What are mutual funds?
Mutual funds pool money from many investors to purchase a portfolio of securities, such as stocks and bonds and other assets. After buying shares of a mutual fund, you’ll share in the gains and losses the fund generates. Different mutual funds have different goals, so be sure to do your research before selecting which funds to invest in.
You’ll encounter both actively managed and passively managed mutual funds. The former may aim to outperform the market or a specific benchmark index by having an advisor actively trade investments, while the latter usually aims to track the performance of an index like the S&P 500, which requires less professional oversight.
Regardless of how a mutual fund is managed, you can buy and sell shares of these funds directly or through intermediaries like brokers and financial advisors. Orders are executed at the fund’s NAV for the day, after the market closes. As a result, all investors who place a mutual fund order on the same day before the cutoff time receive the same price.
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Types of mutual funds
Mutual funds are often categorized based on the types of securities and assets they hold.
Some of the types of mutual funds include:
- Stock (equity) funds: These mutual funds invest primarily in stocks or equities. Stock funds aim for capital growth.
- Bond (fixed income) funds: Funds that invest mainly in bonds and other debt securities. Bond funds typically offer a fixed rate of return.
- Balanced funds: These hold a mix of stocks and bonds in an effort to “balance” income stability and growth potential.
- Money market funds: These funds hold short-term investments issued either by U.S. corporations with high credit ratings or by the U.S. government. These investments have historically been low risk and highly liquid.
- Target date funds: Designed for individuals with a particular cash-out date in mind, target date funds invest in a combination of securities and other assets, automatically adjusting their asset allocation over time.
Each type of mutual fund has its pros and cons. For example, stock funds may offer more growth potential than bond funds, but bond funds may carry less risk and more income stability. Investors can use a combination of different mutual fund types to help achieve their unique investing goals.
What are ETFs?
ETFs are investment vehicles that pool money from many parties to invest in “baskets” of securities and other assets. Like mutual funds, ETFs can be actively or passively managed and come in various forms, including stock funds, bond funds, balanced funds, target date funds and money market funds.
The key difference between ETFs and mutual funds is how they are traded: ETF shares are traded on national stock exchanges throughout the trading day at market prices, like individual stocks. Mutual fund shares, however, typically must be bought or redeemed once per day at the fund’s end-of-day NAV.
ETFs don’t sell or redeem shares directly to or from individual investors. Instead, an intermediary known as an authorized participant typically purchases and redeems shares from ETF sponsors in large bundles, or “creation units.” Authorized participants trade these shares on the secondary market, where individual investors can buy or sell them. As a result, ETF shares may trade at prices above or below the value of their underlying holdings throughout the trading day.
What are index funds?
An index fund is a type of mutual fund or ETF that aims to track the performance of an index like the S&P 500. While you can’t invest directly in market indexes, index funds provide an indirect investment option. An index fund may invest in all the securities included in a market index, or just a sample of them.
Generally, index funds are passively managed, meaning investment advisors aren’t frequently buying and selling securities in the portfolio. This contrasts with actively managed mutual funds and ETFs, where advisors may actively try to outperform the market.
As you explore ETFs and mutual funds, it’s important to keep in mind that index funds can be structured as either.
Similarities between mutual funds and ETFs
Mutual funds and ETFs have several key similarities. Let’s walk through them:
- Investor-funded, pooled portfolios: Money is collected from individual investors, then invested in a shared portfolio that holds a variety of securities and other assets.
- Diversification: The funds invest in baskets of securities, which helps investors reduce their risk by spreading exposure across different assets.
- Multiple types: There are a broad range of ETFs and mutual funds with focuses that include stocks, bonds, a mix of both, or other asset strategies like target date or sector funds.
- Fees: Both charge fees to cover management and administrative costs, though such fees can vary widely.
- SEC regulation: Both are regulated by the U.S. Securities and Exchange Commission (SEC).
- Risk and reward: Both instruments can generate profits through dividend payments, capital gain distributions and share price appreciation. But they also carry the risk of losses – including the possibility of losing some or all of your original investment.
- NAV daily calculation: Both are required to calculate their NAV at least once per day.
Differences between mutual funds and ETFs
Now that you understand the similarities, here are the key differences between mutual funds and ETFs:
- Trading and pricing: ETFs are traded on stock exchanges and can be bought and sold throughout the trading day at market prices. Mutual funds are priced and traded only once per day after the market closes at their daily NAV.
- Advanced trading strategies: Advanced trading strategies, including limit orders, stop orders, margin trading and short selling, can be used with ETFs but not with mutual funds.
- Tax efficiency: The in-kind redemption process of ETFs minimizes taxes for investors, often resulting in lower capital gains distributions compared to mutual funds.
- Minimum investment: Mutual funds in some cases require larger minimum investments than ETFs.
- Automatic investment: Mutual funds may allow for automatic investment and withdrawal plans, making them convenient for recurring contributions. While some brokerage accounts allow for automatic investments in ETFs, ETFs themselves don’t typically offer automatic investment.
- Costs: Mutual funds sometimes have higher fees than ETFs, particularly those that are actively managed.
- Management: Many ETFs are passively managed, while there are many mutual funds that are actively managed.
Mutual Funds | ETFs |
|---|---|
Trading and pricing | |
Can be traded once daily at NAV | Traded intraday at market prices |
Advanced trading | |
Not available | Available (limit orders, short selling, etc.) |
Tax efficiency | |
Less tax-efficient | More tax-efficient due to in-kind redemption process |
Minimum investment | |
Larger minimums in some cases, flat dollar amount | Smaller minimums in some cases (can buy just one share and often fractional shares) |
Automatic investments | |
Available (easy auto-invest/withdrawal plans) | Not typically available directly |
Costs | |
Sometimes higher fees | Sometimes lower fees |
Management style | |
More likely to be actively managed | More likely to be passively managed |
Choosing between mutual funds and ETFs
Both mutual funds and ETFs offer diversified market exposure, but they have different advantages. The intraday trading of ETFs allows you to respond more quickly to market movements. Additionally, the in-kind creation and redemption process for ETFs results in fewer taxable events, which can help you reduce your capital gains tax liabilities. ETFs may have lower expense ratios and investment minimums, which could make them more accessible and cost-effective for some investors.
Mutual funds may have higher fees because there are many that are actively managed, and they are generally less tax-efficient than ETFs. Mutual funds may be a better fit for those looking for an actively managed investment option that meets a specific need.
The bottom line
Both mutual funds and ETFs are worth exploring as investment options, and the best choice for you will depend on your unique goals, preferences and tax situation. In some cases, you may even find that a combination of ETFs and mutual funds provides the right balance for your portfolio.
Frequently asked questions about the differences between mutual funds and ETFs
An ETF is not a mutual fund, although it is similar in many ways. Both ETFs and mutual funds are investment vehicles that pool money from multiple parties to invest in diversified portfolios of securities and other assets. They have a few key differences, however, including how they’re traded and taxed.
Yes, there are ETFs and mutual funds that track the S&P 500 index. These funds aim to mirror the performance of the index by holding the same stocks, or a sample of stocks in the same proportions.
Yes, there are ETFs and mutual funds that invest primarily in bonds. Known as bond ETFs and bond mutual funds, they focus on generating income and preserving capital by holding various types of fixed-income securities that may include government, municipal and corporate bonds.
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Editorial staff, J.P. Morgan Wealth Management
