As you’re looking to invest, you’ll come across two major types of funds: mutual funds and exchange-traded funds. What are they and which is better? ETFs and mutual funds both pool investor money into a collection of securities, allowing investors to diversify without having to purchase and manage individual assets.
But exchange-traded funds are the darlings of the investing world right now, due in part to robo-advisors, which often use them in customer portfolios. Their growth has been rapid: In 2005, there were more than 200 ETFs available to U.S. investors; today, there are nearly 1,800, holding nearly $3 trillion in assets, according to the Investment Company Institute.
Which is better? ETFs offer the best advantage of mutual funds — diversification — and combine it with lower cost and easier access, making them superior to mutual funds. So those reasons are why many investors find ETFs more attractive than mutual funds. Here’s a look at some of the pros and cons of ETFs as compared with mutual funds.
» Learn more: Understand how mutual funds work.
Typically, mutual funds are run by a professional manager who attempts to beat the market by buying and selling stocks using her or his investing expertise. This is called active management, and it often translates into higher costs for investors. ETFs, on the other hand, are usually passively managed funds. These funds automatically track a pre-selected index, such as the S&P 500 or the Nasdaq 100. There are a few actively managed ETFs, which function more like mutual funds and have higher fees as a result.
You might think it’s worth paying more for professional portfolio management, but research indicates the opposite: Actively managed funds rarely beat the market average over time, and most investors earn better returns with low-cost passive index funds, whether they’re ETFs or mutual funds.
An expense ratio indicates how much investors pay each year to own a fund, as a percentage of the amount invested.
ETFs are relatively inexpensive. Some carry expense ratios as low as 0.03%, meaning investors pay just $0.30 per year for every $1,000 they invest. But don’t assume ETFs are always the cheapest option on the menu. It’s worth comparing ETFs and mutual funds when considering your investment options. Actively managed mutual funds almost always carry higher expense ratios than ETFs or index funds in general.
ETFs usually track an index, but they’re index funds with a twist: They’re traded throughout the day like stocks, with their prices based on supply and demand. On the other hand, traditional mutual funds, even those based on an index, are priced and traded at the end of each trading day.
The stock-like trading structure of ETFs also means that when you buy or sell, you often pay a commission, though many brokerages have a selection of commission-free ETFs these days. Pick an account provider that offers at least a few ETFs commission-free. If you’re investing a little bit of money each month, as most investors do, these commissions — which range from $4 to $20 — can add up fast.
If you choose a commission-free ETF, note its expense ratio. Some funds have higher expenses to make up for the lack of commission. And remember that most brokerages require you to hold an ETF for a certain number of days, or they charge you a fee. ETFs aren’t normally intended for day-trading.
Because of how they’re managed, ETFs are usually more tax-efficient than mutual funds. This can be important if the ETF is held within a taxable account and not within a tax-advantaged retirement account, such as an IRA or 401(k).
Mutual funds can have high costs of entry: Even target-date mutual funds, which help novice investors save for specific goals, often have minimums of $1,000 or more. However, ETFs can be purchased by the share, lowering the cost of establishing a position or adding to an existing one. Just keep in mind the trading commissions mentioned above, and choose a commission-free ETF if you can.
Selection is one area where ETFs fall short. The number of ETFs has grown substantially over the last 10 years, but there are still many more mutual funds available. For example, TD Ameritrade has more than 4,000 transaction-fee-free mutual funds and 300 commission-free ETFs. Most investors still find an ETF that meets their needs, but selection is not the security’s strongest point.
Investors shouldn’t assume that any investment is low cost. It’s always important to look under the hood at all potential fees, and that’s true for ETFs, in spite of their reputation for being inexpensive. In general, however, ETFs are an affordable option that gives investors broad market exposure, and they can still provide you with diversification. If you’re ready to get started buying ETFs, see our analysis of the best brokers for ETFs.
One last point: If you’re not a hands-on investor, you may be happier in a target-date fund, which automatically rebalances for you. Investing in ETFs means taking on that duty or outsourcing it to a financial advisor or robo-advisor.
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