Mutual Funds vs. ETFs — What’s the Difference?
When you first start learning about investing, it can feel like you’ve been dropped into a new language. One of the most common questions people ask is, “What’s the difference between a mutual fund and an ETF?”
At a high level, both investment vehicles are ways to pool your money with other investors so you can own a basket of investments—stocks, bonds, alternative investments, etc.—without having to pick and manage them one by one. However, the way they work behind the scenes is a little different, and those differences can matter.
Maybe an illustration will help illuminate the nuances of these investments.
Think of mutual funds like a chef’s special at a restaurant.
You sit down, you order “the special,” and the chef decides what goes on the plate. The mutual fund owner is investing in the chef’s experience, objectives, and track record of making the sort of meal you want to consume. The meal is served once at the end of the day, and everybody who ordered it pays the same price per serving, based on what the ingredients cost when the kitchen closes.
Now let’s talk ETFs—exchange-traded funds.
If mutual funds are the chef’s special, ETFs are more like a buffet. You can walk up anytime the restaurant is open, pick what you want, and pay the going price. The typical passive or index-driven ETF is more like a fixed menu, where the chef’s job is to keep the buffet stocked with an expectation of following a certain theme.
So, what do they have in common?
Both provide you with diversification; you can own a slice of hundreds of companies with one purchase.
Both are run by professional managers, although many ETFs are “passive” and track an index, like the S&P 500 or aggregate bond index.
Both can be cost-effective ways to build a long-term portfolio without having to pick individual stocks.
Where do they differ?
Trading: Mutual funds are priced for trading once a day, at market close. ETFs trade all day long.
Costs: Mutual funds sometimes come with higher fees or sales charges, though many low-cost index funds exist today. ETFs generally have lower expense ratios and no sales loads, though you may pay a brokerage commission depending on your platform.
Active vs. Passive: Many mutual funds actively manage the companies or funds they invest in based on their investment thesis, while ETFs generally follow certain indexes and may require less hands-on work by the manager.
Which is right for you?
The methodology, goals, timeline, or investment ethos held by you or your financial advisor may dictate your use or balance of these investments. If the preference is low correlation to the markets, the typical active management of mutual funds may be helpful for certain allocations. If the preference is to passively track and follow a market, the indexing nature of most ETFs may be worth considering.
The truth is that many investors use both. If your money manager builds a long-term strategy, thoughtfulness around mutual funds and ETFs is an essential ingredient to filling your plate.
Final Thoughts
The key takeaway is this: both mutual funds and ETFs are tools, or options, for building your meal. Neither is “better” in every situation. The best choice depends on your goals, your style, and the methodology of the investor or wealth manager.
So the next time you hear those acronyms thrown around, you’ll know—mutual funds are the chef’s special, ETFs are the buffet line, and both can fill your plate in the right kind of portfolio.