ETFs and Mutual Funds: What’s the Difference?

Introduced to U.S. markets in 1993, exchange-traded funds (ETFs) became the most popularly traded exchange-traded product (ETP) just ten year later in 2013, when ETF net assets totaled $1.34 trillion compared to $14.72 trillion total assets held through investment companies, most of which were in mutual funds. But what is it exactly that distinguishes ETFs from mutual funds?

Like mutual funds, ETFs are a specifically curated collection of investments designed to create a ready-made diversified portfolio to curtail risk.

This is the most salient feature that these two investment products share. From there, however, mutual funds and ETFs begin to diverge. Before investing capital into either of these two investment avenues, it’s important that you understand the differences between them, so you can make the most informed decision for your personal investment strategy.

While mutual funds can only be bought and sold when the markets close each day, ETFs, conversely, can be traded throughout the market day, just like common stocks. This makes them a more flexible investment product.

In general, ETFs are also known for lower costs. While mutual funds are actively managed by a fund manager or investment team, ETFs are often passively managed and calibrated to track a certain market index in order to match the returns and price movements of a certain index, like the S&P 500, for example. This work can usually be accomplished through a computing program, therefore, lowering the costs of operations for the fund.

ETF shares are also bought and sold by individual investors, and not by a fund manager, which also contributes to a lower cost for the ETF investor. Moreover, many of the operational fees associated with buying and selling in a mutual fund don’t apply to ETFs. On average, ETFs holders end up spending less in over-head fees and trading costs.

ETFs are also usually more tax efficient than mutual funds as well.

Both types of funds are taxed annually based on gains and losses, but because ETFs engage in less internal trading, and therefore, less taxable transactions, capital gains tax on holdings are usually lower.