Mutual Fund vs. ETF: What's the Difference?

Mutual Fund vs. ETF: An Overview

Mutual funds and exchange-traded funds (ETFs) are popular ways for investors to diversify but they have some key differences. ETFs can be traded intra-day like stocks but mutual funds can only be purchased at the end of each trading day based on a calculated price known as the net asset value.

Mutual funds have been around for a century. The first mutual fund was launched in 1924. ETFs are relatively new entrants in the investment arena. The first ETF debuted in January 1993: the SPDR S&P 500 ETF Trust (SPY).

Fund managers make decisions about how to allocate assets in a mutual fund so most funds are actively managed. ETFs are usually passively managed. They track market indexes or specific sector indexes. A growing range of actively managed ETFs is available to investors.

Index funds are passively managed and usually come with lower fees. They make up a significant proportion of mutual funds' assets under management.

Mutual Funds

Mutual funds typically have a higher minimum investment requirement than ETFs. Funds with no minimum investment are available but a typical retail fund requires a minimum investment of between $500 and $5,000.

Minimums can vary depending on the type of fund and company. The Vanguard 500 Index Investor Fund Admiral Shares requires a $3,000 minimum investment. The Growth Fund of America offered by American Funds requires a $250 initial deposit.

Many mutual funds are actively managed by a fund manager or team who makes decisions to buy and sell stocks or other securities within that fund to beat the market and help their investors profit. These funds usually come at a higher cost because they require substantially more time, effort, and manpower for securities research and analysis.

Mutual fund purchases and sales occur directly between investors and the fund. The fund's price isn't determined until the end of the business day when net asset value (NAV) is determined.

Types of Mutual Funds

Mutual funds have two legal classifications: open-ended and closed-end. The distinctions between them lie in the fund shares.

Open-Ended Funds

These funds dominate the mutual fund marketplace in volume and assets under management. The purchase and sale of fund shares take place directly between investors and the fund company. There's no limit to the number of shares the fund can issue. More shares are issued as more investors buy into the fund.

Federal regulations require a daily valuation process referred to as marking to market. This subsequently adjusts the fund's per-share price to reflect changes in portfolio value. The value of an individual's shares isn't affected by the number of shares outstanding.

Closed-End Funds

Closed-end funds issue only a specific number of shares. They don't issue new shares as investor demand grows. Prices aren't determined by the net asset value (NAV) of the fund. They're driven by investor demand. Purchases of shares are often made at a premium or discount to NAV.

Exchange-Traded Funds (ETFs)

ETFs can cost far less for an entry position, as little as the cost of one share plus fees or commissions. An ETF is created or redeemed in large lots by institutional investors and the shares trade between investors throughout the day like a stock. ETFs can be sold short.

These provisions are important to traders and speculators but of little interest to long-term investors. ETFs are priced continuously by the market, however, so there's the potential for trading to take place at a price other than the true NAV. This may introduce an opportunity for arbitrage.

ETFs offer tax advantages to investors. As passively managed portfolios, ETFs (and index funds) tend to realize fewer capital gains than actively managed mutual funds.

ETF Creation and Redemption

The creation/redemption process of ETFs distinguishes them from other investment vehicles and provides several benefits. Creation involves buying all the underlying securities that constitute the ETF and bundling them into the ETF structure. Redemption involves unbundling the ETF back into its individual securities.

The ETF creation and redemption process occurs in the primary market between the ETF sponsor and authorized participants (APs). The APs assemble the securities included in the ETF in their correct weights and deliver those securities to the ETF sponsor.

An S&P 500 ETF would require that the APs create ETF shares by assembling all the S&P 500 constituent stocks based on their weights in the S&P 500 index and delivering them to the ETF sponsor. The ETF sponsor then bundles these securities into the ETF wrapper and delivers the ETF shares to the APs. ETF share creation is generally done in large increments such as 50,000 shares. The new ETF shares are then listed on the secondary market and traded on an exchange.

The ETF redemption process is the opposite of ETF creation. APs aggregate ETF shares known as redemption units in the secondary market and deliver them to the ETF sponsor in exchange for the underlying securities of the ETF.

ETF Benefits

The unique ETF creation/redemption process results in ETF prices tracking their net asset value closely because the APs monitor demand for an ETF closely. They act promptly to reduce significant premiums or discounts to the ETF's NAV.

The creation/redemption process also relieves the ETF's fund manager of the responsibility of buying or selling the ETF's underlying securities except when the ETF portfolio has to be rebalanced. An ETF redemption is an "in kind" transaction because it involves ETF shares being exchanged for the underlying securities. It's typically tax-exempt and this makes ETFs more tax efficient.

The process of creating and redeeming shares of a mutual fund can trigger capital gains tax liabilities for all shareholders of the mutual fund but this is less likely to occur for ETF shareholders who aren't trading shares. The ETF shareholder is still on the hook for capital gains tax when the ETF shares are sold but the investor can choose the timing of such a sale.

Types of ETFs

ETFs have three structures.

Exchange-Traded Open-End Fund

The majority of ETFs are registered under the SEC's Investment Company Act of 1940 as open-end management companies.

This ETF structure has specific diversification requirements. No more than 5% of the portfolio can be invested in securities of a single stock. This structure offers greater portfolio management flexibility compared to the Unit Investment Trust structure because it's not required to fully replicate an index. Several open-end ETFs use optimization or sampling strategies to replicate an index and match its characteristics rather than owning every single constituent security in the index.

Open-end funds are also permitted to reinvest dividends in additional securities until distributions are made to shareholders. Securities lending is allowed and derivatives can be used in the fund.

Exchange-Traded Unit Investment Trust (UIT)

Exchange-traded UITs also are governed by the Investment Company Act of 1940 but these must attempt to fully replicate their specific indexes to limit tracking error. They must limit investments in a single issue to 25% or less and set additional weighting limits for diversified and non-diversified funds.

The first ETFs such as the SPDR S&P 500 ETF were structured as UITs. They don't automatically reinvest dividends but pay cash dividends quarterly. They're not permitted to engage in securities lending or hold derivatives. Some examples of this structure include the QQQQ and Dow DIAMONDS (DIA).

Exchange-Traded Grantor Trust

This is the preferred structure for ETFs that invest in commodities. They're structured as grantor trusts which are registered under the Securities Act of 1933 but not registered under the Investment Company Act of 1940.

This type of ETF bears a strong resemblance to a closed-ended fund but an investor owns the underlying shares in the companies in which the ETF is invested. This includes holding the voting rights associated with being a shareholder. The composition of the fund doesn't change, however. Dividends aren't reinvested but are paid directly to shareholders. Investors must trade in 100-share lots. Holding company depository receipts (HOLDRs) is one example of this type of ETF.

A Detailed Comparison: Mutual Funds vs. ETFs

Mutual funds and ETFs both offer the opportunity to more easily gain exposure to a large number of securities. Both are managed by a fund manager who tries to achieve the stated investment goals of the fund. An S&P 500 mutual fund or ETF typically tries to match the makeup and returns of the S&P 500 index. Investors can buy shares in the fund to get exposure to all the securities that it holds. Fund managers charge a fee called an expense ratio in exchange for managing the fund.

One of the key differences between ETFs and mutual funds is in how they're traded. You buy and sell shares directly with the fund provider with mutual funds. Transactions also only occur after trading ends for the day and the fund's manager can calculate the value of a share in the fund.

ETFs trade more like stocks. You can buy and sell shares in an ETF on the open market with other investors. It's also possible to buy or redeem shares with the fund provider but this is less common. Shares trade throughout the day rather than after the market closes so ETFs are a better choice for active traders.

ETFs are often cheaper to invest in as well. Mutual funds typically have minimum investment requirements of hundreds or thousands of dollars. You can invest in an ETF if you have enough money to buy a single share. ETFs are usually passively managed. Some mutual funds have more active management so ETF expense ratios are usually lower.

Mutual Fund vs. ETF Redemption Example

Suppose an investor redeems $50,000 from a traditional Standard & Poor's 500 Index (S&P 500) fund. The fund must sell $50,000 in stock to pay the investor. The fund captures the capital gain if appreciated stocks are sold to free up the cash for the investor. This is distributed to shareholders before the year's end.

Shareholders pay the taxes for the turnover within the fund as a result. The ETF doesn't sell any stock in the portfolio if an ETF shareholder wants to redeem $50,000. It instead offers shareholders "in-kind redemptions" that limit the possibility of paying capital gains tax.

The Bottom Line

Mutual funds and exchange-traded funds are two popular ways for investors to diversify their portfolios rather than betting on the success of individual companies. The main difference is that ETFs can be traded throughout the day just like an ordinary stock. Mutual funds can only be sold once a day after the market closes.

Investopedia does not provide investment advice. Investors should consider their risk tolerance and investment objectives before making investment decisions.