ETFs Vs. Mutual Funds: Which is Better?

Both mutual funds and exchange-traded funds (ETFs) consist of many different assets and are commonly employed to help investors diversify their portfolios. But there are key differences in how they are managed.

Which is What?

An ETF is...

Let's use the Investopedia definition: An exchange traded fund (ETF) is a type of security that tracks an index, sector, commodity, or other asset, but which can be purchased or sold on a stock exchange the same as a regular stock. An ETF can be structured to track anything from the price of an individual commodity to a large and diverse collection of securities. ETFs can even be structured to track specific investment strategies.

An ETF is called an exchange traded fund since it's traded on an exchange just like stocks. The price of an ETF’s shares will change throughout the trading day as the shares are bought and sold on the market.

There are three kinds of ETFs: exchange-traded open-end index mutual funds, unit investment trusts, and grantor trusts.

A Mutual Fund Is...

Let's use the Yahoo Finance definition: The word “mutual” used in the term “mutual fund” refers to the structure of the fund rather than the investment strategy that the fund’s owners pursue. This kind of fund combines the funds of investors who mutually pool their monies to buy and sell securities. Investing in a mutual fund is not trading shares of specific companies held by the mutual fund; it is trading shares of the mutual fund company itself. Investors buy and sell their stakes in mutual funds at a price set at the end of a trading session; their value does not fluctuate throughout the trading session.

Mutual funds can be open-ended - where trading is between investors and the fund and where the number of shares available has no limit, or closed-end - where the fund issues a specific number of shares regardless of demand.

Buying & Selling

‍Buying or selling ETFs is an easy transaction at one price… a single deal away from an open or close position in the market. Mutual funds require calling customer service, completing paperwork, and then waiting for the transaction to occur. Additionally, ETFs tend to be more cost-effective and more liquid when compared to mutual funds.

Taxes

‍Taxation is a major advantage of ETFs over ordinary mutual funds. ETFs accrue and incur capital gains taxes only when they are sold. Mutual funds incur capital gains taxes whenever the shares are traded within the lifecycle of the investment.

Choosing an ETF can reduce the tax bill on long term investments.

Fees

Mutual funds, except for index funds, are managed by a fund manager who makes decisions about the allocation of assets within the fund. Mutual funds often have higher fees and higher expense ratios than ETFs, which in part reflects the costs of active management.

ETFs tend to be more cost-effective and more liquid when compared to mutual funds.

Diversification

Both mutual funds and ETFs offer diversified portfolios, but depending on your financial objectives, appetite for risk, and timeframe, the difference is clear for people who prefer the quick liquidity of ETFs vs the long term investment features of mutual funds.

In Sum

In summary, ETFs appear to be the more popular option, offering benefits like low commissions, tax advantages, and easy tradability.

A judicious mix might be best, but in my mind, there is no clear answer to which is superior. As usual, it depends…