Thefollowing was authored by Paige Kyle, Capital Markets Associate at WisdomTree.
One of the most common questions and discussion points we encounter is: “What are the key differences between exchange traded funds (ETFs) and mutual funds?” Both are investment vehicles designed to give the investor exposure to a basket of securities, but there are important distinctions between the two structures in terms of transparency, trading and tax efficiency. Our CEO, Jonathan Steinberg, likes to use the analogy that mutual funds are like black-and-white TVs and ETFs are like HDTVs in full color.
The first key difference between ETFs and mutual funds is transparency. The holdings of ETFs are published daily, so as an investor, you know exactly what you are holding. Mutual fund holdings are published quarterly and usually on a lagging basis. By the time the holdings are published, what the mutual fund actually holds could be quite different. Furthermore, ETFs are much more transparent in terms of trading costs. The ETF buyer or seller bears the trading cost without impacting other investors of the fund. Additionally, the trading costs are imbedded in the ETF spread, which the buyer or seller pays, plus commissions. For mutual funds, the costs of inflows and outflows are borne by all holders of the mutual fund. Any trading activity that occurs in the portfolio, such as trading to accommodate daily inflows and outflows, will impact those who hold the mutual fund. In terms of fees, many mutual funds have sales loads, 12b-1 fees and trading costs that are not transparent since they are not exchange traded. Many investors think they are getting net asset value (NAV) but in reality, it is NAV minus the unknown trading costs.
The second key difference between the two products is trading. A mutual fund investor can only receive NAV minus costs of a mutual fund at the end of each day. An ETF can be bought or sold throughout the entire trading day. Additionally, since an ETF is exchange traded, that adds a further layer of liquidity. Shares of an ETF have the potential to be passed back and forth on exchange without a transaction occurring in the underlying securities. This can potentially lead to cheaper costs compared to trading the underlying basket. This does not happen with a mutual fund. The portfolio manager will always have to transact in the underlying securities when buying or selling for an investor, especially in larger size.
The last key difference between mutual funds and ETFs is tax efficiency. While both structures are taxed equally on the individual level, the key difference occurs at the fund-holdings level. At the end of the year, if the fund had netted gains from selling securities, this amount must be distributed to the fund’s shareholders, who are then required to pay taxes on this distribution. ETFs are more tax efficient on the fund-holdings level due to their exchange-traded nature. Shares of the ETF can be passed back and forth on the exchange without creating turnover in the underlying portfolio, thereby reducing the chance for capital gains. The second contributing reason is due to the “in-kind” creation and redemption mechanism. Securities and ETF shares are exchanged between the authorized participant and the ETF issuer during a creation or redemption, free of payment, meaning no transactions occurred within the portfolio. Mutual funds have neither of these benefits, making them more prone to taxable events.
While ETFs and mutual funds are both a wrapper around a basket of securities, there are many key differences. ETFs provide much more transparency, flexibility, tradability and tax efficiency compared to their mutual fund counterparts. The investor knows exactly what he or she holds, and all of the costs and fees are transparent. Furthermore, an ETF investor will not be impacted by the actions of other holders of that ETF, whereas a mutual fund investor is at the mercy of other holders of that fund. So in a world of technology, would you prefer a black-and-white TV or a flat-screen color HDTV?
Important Risks Related to this Article
Neither WisdomTree Investments, Inc., nor its affiliates, nor Foreside Fund Services, LLC, or its affiliates provide tax advice. All references to tax matters or information provided on this site [in this material] are for illustrative purposes only and should not be considered tax advice and cannot be used for the purpose of avoiding tax penalties. Investors seeking tax advice should consult an independent tax advisor.
FAQs
While they can be actively or passively managed by fund managers, most ETFs are passive investments pegged to the performance of a particular index. Mutual funds come in both active and indexed varieties, but most are actively managed. Active mutual funds are managed by fund managers.
What age owns the most mutual funds? ›
In 2022, it was observed that 55 percent of the households whose head was in the 42-57 age range owned shared in a mutual fund in the United States. However, only 36 percent of households where the head was aged between 18 and 25 owned shares in a mutual fund.
What are the major potential benefits of the ETF structure compared that of mutual funds? ›
Exchange-traded funds (ETFs) take the benefits of mutual fund investing to the next level. ETFs can offer lower operating costs than traditional open-end funds, flexible trading, greater transparency, and better tax efficiency in taxable accounts.
Are ETFs good for older investors? ›
ETF benefits, including simplicity, low expenses and tax efficiency, make exchange-traded funds a worthwhile investment for retirement. Popular types of ETFs for retirement include dividend ETFs, fixed-income ETFs and real estate ETFs.
What are 3 differences between mutual funds and ETFs? ›
Mutual funds and ETFs may hold stocks, bonds, or commodities. Both can track indexes, but ETFs tend to be more cost-effective and liquid since they trade on exchanges like shares of stock. Mutual funds can offer active management and greater regulatory oversight at a higher cost and only allow transactions once daily.
What are three main differences between ETFs and mutual funds? ›
Mutual funds are priced once a day at the net asset value and they're traded after market hours. ETFs are traded throughout the day on stock exchanges just as individual stocks are. ETFs often have lower expense ratios and are generally more tax-efficient due to their more passive nature.
What is the 120 age rule? ›
The 120-age investment rule states that a healthy investing approach means subtracting your age from 120 and using the result as the percentage of your investment dollars in stocks and other equity investments.
Do millionaires use mutual funds? ›
Cash equivalents are financial instruments that are almost as liquid as cash and are popular investments for millionaires. Examples of cash equivalents are money market mutual funds, certificates of deposit, commercial paper and Treasury bills. Some millionaires keep their cash in Treasury bills.
How old are mutual funds? ›
The first mutual fund in the United States was created in 1924, which means that mutual funds and other pooled investment products have been part of our country's economic success story for one hundred years.
Why use ETFs instead of mutual funds? ›
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.
Key Takeaways. Many mutual funds are actively managed while most ETFs are passive investments that track the performance of a particular index. ETFs can be more tax-efficient than actively managed funds due to their lower turnover and fewer transactions that produce capital gains.
What is the downside of ETFs? ›
For instance, some ETFs may come with fees, others might stray from the value of the underlying asset, ETFs are not always optimized for taxes, and of course — like any investment — ETFs also come with risk.
Why are ETFs more risky than mutual funds? ›
While these securities track a given index, using debt without shareholder equity makes leveraged and inverse ETFs risky investments over the long term due to leveraged returns and day-to-day market volatility. Mutual funds are strictly limited regarding the amount of leverage they can use.
Are ETFs good for retirees? ›
Vanguard S&P 500 ETF
For those who want to enjoy retirement, there are two primary goals. First, you must protect your money. Second, you want to create passive income that helps pay your living expenses without selling your investments. Exchange-traded funds (ETFs) are a great tool to achieve both goals.
What are the disadvantages of ETFs compared to mutual funds? ›
Limited Capital Gains Tax
As passively managed portfolios, ETFs (and index mutual funds) tend to realize fewer capital gains than actively managed mutual funds. Mutual funds, on the other hand, are required to distribute capital gains to shareholders if the manager sells securities for a profit.
Why buy an ETF instead of a mutual fund? ›
ETFs offer numerous advantages including diversification, liquidity, and lower expenses compared to many mutual funds. They can also help minimize capital gains taxes. But these benefits can be offset by some downsides that include potentially lower returns with higher intraday volatility.
Are ETFs riskier than mutual funds? ›
While these securities track a given index, using debt without shareholder equity makes leveraged and inverse ETFs risky investments over the long term due to leveraged returns and day-to-day market volatility. Mutual funds are strictly limited regarding the amount of leverage they can use.
Is S&P 500 a mutual fund or ETF? ›
Index investing pioneer Vanguard's S&P 500 Index Fund was the first index mutual fund for individual investors.
