Mutual Funds vs. ETFs: What’s the Difference?

Mutual funds and exchange-traded funds (ETFs) are both created from the concept of pooled fund investing. Pooled funds bundle securities together to offer investors the benefit of a diversified portfolio. The pooled fund concept primarily offers diversification and comes with economies of scale, allowing managers to decrease transaction costs through large lot share transactions with pooled investment capital.

Both mutual funds and ETFs will typically have anywhere from 100 to 3,000 different individual securities within the fund. Both types of investments are also primarily regulated by the three principal securities laws enacted after the market crash of 1929.

• Securities Act of 1933
• Securities and Exchange Act of 1934
• Investment Company Act of 1940

While these two investment products are built from the same pooled fund concept and regulated by the same principal securities laws, there are unquestionably some significant differences between the choices. These differences can be appealing depending on the investor.

One of the main differences is that most ETFs are built to track an index. Alternatively, mutual funds have historically been developed to offer a broader range of choices. Mutual funds span from passive index funds to several types of actively managed strategies.

MFS Investment Management offered the first U.S. mutual fund in 1924. Since the 1920s mutual funds have been providing investors an extensive selection of pooled fund offerings. While some mutual funds are passively managed, many investors look to these securities for the added value they can offer in an actively managed strategy. For these investors, active management is the key differentiator as they rely on a professional manager to build an optimal portfolio rather than just following an index.

Of the two options, as the leading, actively managed investment, mutual funds come with some added complexities. Typically, management fees will be higher for a mutual fund because managers are tasked with a more difficult job in identifying the best securities to fit the portfolio’s strategy. Mutual funds have also had long-standing integrated into the full-service brokerage transaction process. This full-service offering is the primary reason for the structuring of share classes, and also may add some additional fee considerations.

Mutual funds are created to be offered with multiple share classes. Each share class has its fee structuring that requires the investor to pay different types of sales loads to a broker. Different share classes also have varying types of operational fees. 

The operational fees of a mutual fund are comprehensively expressed to the investor through the expense ratio. The expense ratio is made up of management fees, operational expenses, and 12b-1 fees. 12b-1 fees are a fundamental differentiator between mutual funds and ETFs. The mutual fund requires 12b-1 fees to support the costs associated with selling the fund through full-service brokerage relationships. The 12b-1 fees are not needed with ETFs, and therefore, can make the mutual fund expense ratio slightly higher.

It is also vital for an investor to understand the pricing of mutual funds. Mutual funds are priced based on a net asset value (NAV) which is calculated at the end of the trading day. Standard open-end mutual funds can only be bought and sold at their NAV which means an investor placing a trade during the trading day must wait until the final price is calculated to transact their order.

The first ETFs began trading in 1993. Regulations primarily required these funds to be passively managed with securities tracking an index. In 2008, regulatory changes began to make actively managed ETFs available for U.S. investors.

Historically, ETFs have been popular for index investors seeking to gain exposure to a particular market segment with the benefits of having diversification across the sector. Following the 2008 market crisis, the popularity of smart beta funds began to increase. Within the ETF offering arena, smart beta provides a type of customized index product built around a factor-based index methodology. This customization lets investors choose from index options with selected fundamental characteristics which, in many cases, can substantially outperform. With the evolution of smart beta index funds, ETF options have widened, giving investors a broader variety of passive ETF choices.

Fees are also an important consideration for ETF investors. ETFs do not carry sales load fees. Investors will pay a commission if required for trading them, but many ETFs trade for free. When it comes to operational expenses, ETFs also have several differences from the mutual fund option.

ETF expenses are usually lower for a few reasons. ETFs have lower management fees because many of them are passive funds which do not require stock analysis from the fund manager. Transaction fees are also typically lower as less trading is needed. As mentioned, ETFs also do not charge 12b-1 fees which decreases the overall expense ratio.

The pricing of ETFs also differs from mutual fund pricing. An important consideration when comparing the two. ETFs trade throughout the day on exchanges like a stock. This active trading can appeal to many investors who prefer real-time trading and transaction activity in their portfolio. Overall, the price of an ETF reflects the real-time pricing of the securities held within the portfolio.

Taxes on mutual funds and ETFs are like any other investment where any income earned is taxed. Investors must pay either the short-term or long-term capital gains tax when selling their shares for a profit. Short-term capital gains apply to shares held less than one year before selling. Long-term taxes include the profit from shares sold after holding for a year or longer.

For 2018, short-term capital gains are taxed at the ordinary income tax rate. Long-term capital gains are taxed at 0%, 15%, and 20% depending on the investor's ordinary income tax bracket. Investors in mutual funds and ETFs must also pay taxes on any dividends they receive from the holding. Ordinary dividends are taxed at the ordinary income tax rate. Qualified dividends are taxed at the long-term capital gains rate.

Mutual funds typically have higher tax implications because they pay investors capital gains distributions. These capital distributions paid out by the mutual fund are taxable. ETFs usually do not payout capital distributions, and therefore, can have a slight tax advantage.

For investors who hold their assets in a tax-advantaged vehicle like a 401(k), this advantage disappears. 401(k)s and other qualified plans take contributions on a tax-deferred basis. Money that is deposited—up to certain yearly limits—is not subject to any income tax. Further, the investments in the account can grow tax-free and do not incur taxes when trades are made.