ETF vs. Mutual Fund: It Depends on Your Strategy

The basic case for using exchange-traded funds (ETFs) or mutual funds is pretty simple: Both fund types are managed "baskets" of individual securities that can offer exposure to a wide variety of asset classes—including stocks, bonds, and more—as well as particular market niches. Accordingly, they generally provide more diversification than a single stock or bond could. And you can use them to create a diversified portfolio by combining funds from multiple asset classes.

So much for the similarities. The next question is: How do you choose between them?

As we'll see below, these funds are structured differently, which affects the way they trade and possibly how they're taxed. And depending on the kind of fund management you prefer, they may come with very different costs. Here are some questions to ask when choosing.

ETFs trade like stocks and are bought and sold on a stock exchange, experiencing price changes throughout the trading day. This means that the price at which you buy an ETF will likely differ from the prices paid by other investors. 

Mutual funds are generally bought directly from investment companies instead of from other investors on an exchange. Orders are executed once per day, with anyone who invests on the same day receiving the same price.

Most ETFs are considered "passive" investments because they are designed to passively track the performance of a particular index. They might do this by owning many of the same securities held in equal portions to their representation on that index. For example, an ETF tracking the S&P 500^® Index might seek to own all 500 of the index's stocks. Given that, they may change their holdings only when the index adds or removes new constituents. That said, fund managers do have the discretion to substitute and leave off some securities, so long as their fund's performance doesn't stray too far from that of the index it's supposed to track. 

By definition, passive funds generally don't "beat" the market they are tracking, because their goal is to faithfully replicate it. Think of such funds as following the tortoise's "slow and steady wins the race" philosophy. If the market falls, a passively managed ETF will generally follow it down. 

You can find actively managed ETFs, in which fund managers actively buy and sell securities in the hope of beating an index benchmark (though most aren't able to do so consistently). But such funds aren't as common.

Most mutual funds are actively managed, though there are several hundred passive index-tracking mutual funds out there. 

To expand on the brief sketch above: Active portfolio managers, possibly backed by a team of research analysts, select and manage the assets in their fund with an eye toward beating whatever benchmark they're using to measure their performance. This could mean delivering higher returns than the S&P 500 in a given year, or, in rough markets, playing defense by selling more speculative or risky assets and adding more conservative investments.

Before getting into the different cost structures, it's important to understand that a fund manager will charge you a lot less to passively follow an index, whether with an ETF or index mutual fund, than to do a lot of research and trading for an active fund. In fact, some passive ETFs and mutual funds might charge nothing at all, according to data from Morningstar. That's a sizeable advantage over actively managed funds that charge an average of 0.60%.¹ As for the other costs:

Some ETF costs are explicit, such as any commissions you might have to pay to place a trade, or the fund's operating expense ratio (OER), which the manager charges to pay for portfolio management, administration, and other costs. Your broker will disclose the cost of commissions and the ETF provider will disclose the OER (if either apply). But you also need to pay attention to implicit costs, such as a wide bid/ask spread, which refers to situations when the price to buy shares is higher than the price to sell them. The spread can be particularly large for ETFs that don't trade very frequently.

An ETF may also experience changes in discounts and premiums to its net asset value (NAV). An ETF is said to be trading at a premium when its market price is higher than its NAV—simply stated, when you're paying a bit more for the ETF than its holdings are actually worth. An ETF is said to be trading at a discount when its market price is lower than its NAV—that is, you're buying the ETF for less than the value of its holdings. Changes to either can drag or boost performance depending on how they move during the time you hold the ETF.

Investors should remember that an ETF's total cost of ownership is a combination of its operating expenses and costs of trading. Your investing strategy as well as the specific ETFs that you select for your portfolio can make a big difference in the total cost.

Mutual funds don't have trading commissions. (Remember, they don't trade on exchanges.) But they do carry an expense ratio—or a percentage of fund assets taken out annually to cover fund operating expenses—and the fund company may charge a sales fee known as a load. This is a one-time commission some fund companies charge whenever you buy or sell shares to compensate the broker. Other fees may also apply.

ETFs often generate fewer capital gains for investors than mutual funds. This is partly because so many of them are passively managed and don't change their holdings that often. However, ETFs also have a structural ability, called the in-kind creation/redemption mechanism, to minimize the capital gains they distribute.

Sales of securities within a mutual fund may trigger capital gains for shareholders—even for those whose investment is down from when they first bought it. Actively managed funds tend to have a higher tax cost than index funds because frequent trading can lead to more taxable capital gains. The more activity in a fund, the more those taxes add up.

Because they trade like stocks, ETFs do not require a minimum initial investment and are purchased as whole shares. You can buy an ETF for the price of just one share, usually referred to as the ETF's "market price."

Minimum initial investments for mutual funds are normally a flat dollar amount and aren't based on the fund's share price. Unlike ETFs, mutual funds can be purchased in fractional shares or fixed dollar amounts.

As you can see, there are a lot of factors to consider, but here are a few rules of thumb:

• You trade actively. Intraday trades, stop orders, limit orders, options, and short selling—all are possible with ETFs, but not with mutual funds.
• You're tax sensitive. ETFs and index mutual funds tend to be generally more tax efficient than actively managed funds. And, in general, ETFs tend to be more tax efficient than index mutual funds.
• You want niche exposure. Specific ETFs focused on particular industries or commodities can give you exposure to market niches. Niche investing often isn't possible with index mutual funds, though some actively managed niche mutual funds might be available.

• You invest frequently. If you make regular deposits—for example, you use dollar-cost averaging—a no-load index mutual fund can be a cost-effective option, and it allows you to fully invest the same dollar amount each time (since mutual funds can be purchased in fractional shares).
• You can buy an index mutual fund that has lower annual operating expenses. Don't assume ETFs are always going to be the lowest-cost option. You may be able to find an index mutual fund with lower costs than a comparable ETF.
• Similar ETFs are thinly traded. As we covered earlier, infrequently traded ETFs could have wide bid/ask spreads, meaning the cost of trading shares of the ETF could be high. Mutual funds, by contrast, always trade without any bid-ask spreads.

• You're looking for a fund that could potentially beat the market. As noted above, a successful fund manager could potentially give you better returns than other parts of the market, but keep in mind that it is hard to do this consistently over time. Also, actively managed funds acquired as part of a specific strategy can help complement the index funds in your portfolio. They can also help to reduce risk and mitigate market volatility.
• You're investing in a less efficient market. Some markets are considered "inefficient," meaning the fundamentals of the assets being traded aren't widely understood and information about market conditions can be harder to come by. Think emerging market stocks or high-yield bonds. Professional active fund managers who can draw on deep research and a proven strategy may do better in such markets. In more efficient markets, businesses or markets are so popular and information is so quickly and widely distributed that there isn't much opportunity for active managers to add value. Large-cap U.S. stocks are an example of the latter.

At the end of the day, it might not be an either-or question. Having some of each type of fund can help diversify your portfolio across multiple dimensions. And if you have both tax-deferred, after-tax, and taxable accounts, you may have options for managing the tax liability of multiple types of funds.