Mutual funds and exchange-traded funds (ETFs) are two of the most common ways for Americans to invest. These investments have some important similarities but also have some key differences.
Both mutual funds and ETFs are pooled investment funds that offer investors a stake in a diversified portfolio. Investors have many fund choices from which to gain exposure to a wide array of markets, industry sectors, regions, asset classes and investment strategies, as outlined in the fund’s prospectus.
Here are some other ways the two investment products are similar:
- Both are quite liquid. ETF shareholders can trade throughout the day, just as with stocks. Mutual fund investors can usually redeem their shares with ease on a daily basis.
- They come with risk. Both mutual funds and ETFs can lose money, and how a fund performed in the past is not an indication of how it will perform in the future.
- They have fees and expenses. Mutual funds and ETFs both charge “Annual Fund Operating Expenses,” also known as expense ratios (and expressed as a percentage). In addition, mutual funds often charge other fees, and there are generally brokerage commissions when you buy or sell and ETF. Learn more about mutual fund fees and ETF fees.
- You don’t get to choose the securities in either an ETF or mutual fund, but you can find top holdings and other information through online resources and a fund’s prospectus.
- There are active and passive versions of both fund types.
The biggest differences between mutual funds and ETFs are in how they’re priced, purchased and sold.
- Mutual funds are required by law to price their shares at NAV each business day, and they typically do so after the major U.S. exchanges close. NAV, which stands for net asset value, is the per-share value of the mutual fund’s assets minus its liabilities. In contrast, ETFs trade on a stock market like individual stocks, and prices fluctuate throughout the day. ETFs also calculate their NAV each day, but the per-share price of an ETF can deviate from the per-share NAV throughout the trading day.
- Another subtler difference: Investors purchase and redeem shares in a mutual fund directly from the mutual fund or through a brokerage firm that sells the fund. Meanwhile, ETF investors buy or sell shares of an ETF on an exchange, as they would any other publicly traded stock, allowing for what’s known as “intraday liquidity.” In short, with an ETF, pricing is continuous—you don’t have the potential price uncertainly that comes with end-of-day mutual fund pricing.
- ETFs generally give investors more control over their tax liability. An investor can choose when to sell ETF shares—basically deciding if or when a capital gains liability occurs. You’ll have to pay taxes on any realized capital gains when you do ultimately sell, however, and are also responsible for reporting any dividend and interest payments you receive. Investors can also choose when to sell mutual fund shares. But with mutual funds, a tax liability can also occur when the fund manager sells holdings with embedded capital gains.
To sum up, both mutual funds and ETFs can provide diversification, flexibility and exposure to a wide array of markets at a relatively low cost. But as is the case with any investment product, it pays to be informed and understand the differences between the two types of investment funds before you make any decision.