When you’re investing, it’s typically a good idea to diversify the stocks, bonds or other investments that you own. But most of us don’t have the expertise or time to do it. That’s where funds come in. They allow you to make one purchase and get a basket of underlying investments.
Mutual funds and exchange-traded funds (ETFs) are some of the most common funds. But what are mutual funds and ETFs? While they both allow you to buy a basket of investments, they have some key differences.
Below, we take a closer look at both ETFs and mutual funds, highlighting the key differences. We answer other questions that investors commonly ask about these types of funds.
What is a mutual fund?
A mutual fund is a type of investment fund that allows you to pool your money together with the money of other investors. These funds are then used to purchase assets according to the goals and objectives of the fund (and its shareholders).
- Mutual fund companies issue the fund. Along with their competitors, companies like Fidelity Investments, Franklin Templeton and Russell Investments offer thousands of mutual funds.
- Fund managers choose which assets to buy and sell (and when). Their decisions must be in the best interests of mutual fund shareholders.
- Investors purchase shares of the fund. Many people are attracted to the diversification these funds offer. Mutual funds can only be purchased daily, and their price changes only once daily.
Mutual funds commonly specialize in stocks or bonds. That being said, some mutual funds invest in other types of assets or multiple different asset classes.
You may have heard of a target-date fund, which is technically a type of mutual fund. These funds become more conservative over time by shifting the fund’s allocation as the investors’ target date (the date at which they plan to begin accessing their funds) gets closer. Target-date funds are commonly used as vehicles to save for retirement. Keep in mind the principal value, including at the target date, is not guaranteed.
What is an ETF?
Think about an exchange-traded fund (ETF) as its three components:
- Exchange: Shares of ETFs can be bought and sold on a stock exchange, much like common stock.
- Traded: The share price can fluctuate over the course of a day as those shares are traded.
- Fund: As a fund, an ETF holds a variety of different investments—potentially hundreds or even thousands of different assets.
With this in mind, you can think of an ETF as something like a cross between a mutual fund and a stock. Like mutual funds, ETFs bundle together a variety of different assets, making them an excellent means of diversifying a portfolio. But like stocks, ETFs can be bought and sold throughout the day via an exchange.
Much like mutual funds, ETFs are issued by sponsoring companies. Likewise, they are also managed by professional fund managers according to the goals of the ETFs and their shareholders.
What about index funds?
An index fund is a specific type of investment fund that is designed to track the performance of a particular market index, such as the S&P 500 or the Nasdaq composite. An index fund can take the form of an ETF or a mutual fund, depending on which organization issues and manages it.
Key differences between mutual funds and ETFs
Below is an overview of the main differences between ETFs and mutual funds that you should be aware of before you begin investing.
Mutual funds and ETFs both come in actively managed and passively managed varieties. Passive management is sometimes known as a “buy-and-hold” portfolio strategy because it aims for minimal trading and does not attempt to capitalize on short-term price fluctuations. ETFs veer toward passive management, while mutual funds tend veer toward active management.
This means that the composition of a mutual fund is likely to change more frequently over time as the fund manager buys and sells assets to attempt to outperform the rest of the market. The composition of ETFs tends to change much less frequently, especially if the fund is pegged to an index.
A fund’s expense ratio is simply a figure that tells investors how much they must pay each year to own shares of that fund. It’s typically expressed as a percentage of the amount invested, and both mutual funds and ETFs carry expense ratios that are passed on to the funds’ shareholders. But because ETFs are predominantly passively managed, they tend to have lower expense ratios compared to actively managed mutual funds.
Investors can buy and sell shares of an ETF on a stock exchange, just as they would with shares of any other publicly traded stock. This means that you can purchase shares of an ETF at any point during the trading day. For this reason, an ETF’s share price will fluctuate throughout the course of a day.
Shares of a mutual fund, by comparison, can be bought or sold only once per day. Typically, this is at the end of the day after market close. This means that a mutual fund’s share price (also called the net asset value, or NAV) is updated only once per day, based on the underlying value of the securities held in the fund and shares outstanding. Unlike ETFs, the price of a mutual fund does not fluctuate throughout the day. So, ETFs are often considered to be more “liquid” investments than mutual funds.
In order to buy into a mutual fund, investors will commonly need to invest a certain amount of money, known as the “minimum investment.” This minimum investment varies from fund to fund but can range from a few hundred to a few thousand dollars—which some investors may not be able to meet.
ETFs, on the other hand, do not carry minimum investments. As long as investors have enough money to buy one share of the fund, they can do so.
As mentioned above, mutual funds are more likely to be actively managed. This means that the fund is more likely to buy (and sell) assets in an attempt to generate a return for shareholders. These asset sales can make it necessary for shareholders to pay capital gains taxes—even if they do not sell any of their shares.
Because ETFs are more likely to be passively managed, they typically experience lower turnover and fewer asset sales, which usually results in fewer capital gains taxes compared to mutual funds.
Mutual fund vs. ETF: Which is right for you?
Mutual funds and ETFs both make it easy for you to diversify your investment portfolio, especially compared to choosing individual stocks or bonds.
But, as discussed above, there are certain key differences between the two types of funds. These differences might mean that one or the other is better suited to helping you reach your financial goals, so it’s important to consider all of your options before you make any choice.
It’s possible a mix of both could also work for your situation. A Northwestern Mutual financial advisor can get to know you and your unique goals and then help you build a financial plan that includes investments for growth as well as other financial tools to help you manage risks to your plan.
Exchange traded funds (ETFs) have risks and trade similar to stocks. Shares of ETFs are bought and sold in the market at a market price, as a result, they may trade at a premium or discount to the fund's actual net asset value. Investors selling ETF shares in the market may lose money including the original amount invested. All investments carry some level of risk, including loss of principal invested. No investment strategy can guarantee a profit or protect against loss.
Get our monthly Life & Money newsletter filled with financial tips, tools, and more.