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Mutual funds vs. ETFs: Which is better?

Picture of Lucas Nettles, CFP®, CKA®

Lucas Nettles, CFP®, CKA®

Mutual funds and exchange-traded funds (ETFs) are two ways to invest in a group of assets via a single product. Both mutual funds and ETFs pool investor money to buy or track various securities — things like stocks, bonds, commodities, real estate, or similar. 

While ETFs tend to be more prevalent with retail investors, mutual funds still feature prominently in many workplace 401(k) plans. With that in mind, it’s important for you to understand what ETFs are, what mutual funds are, how the two are similar and different, and what to consider before using either.

What are mutual funds?

Mutual funds pool money from various investors and use it to invest in a basket of securities—stocks, bonds, commodities, and so on. These funds tend to be managed by a professional manager with a specific goal in mind. For instance, some funds might track the S&P 500, others might focus on international stocks, and so on. 

Some mutual funds involve multiple share classes or require you to pay a load fee when buying into or exiting the fund. As such, it’s important to understand any associated fees and expenses involved in a mutual fund, as these may eat into your potential investment returns.

Details about the fund manager’s approach, as well as the fees you pay for professional fund management, are outlined in the fund’s prospectus. Pay particular attention to the fund goals or investment objectives and the net expense ratio.

Some of the most commonly-featured mutual funds in retirement accounts are target-date funds. These funds adjust their allocations based on a future retirement date. For instance, if you anticipate retiring in 2060, the fund would start with a more aggressive growth allocation, and begin shifting towards a more conservative allocation (likely with more bonds) as that 2060 date approaches.

What are ETFs?

Like mutual funds, exchange-traded funds (ETFs) pool money to invest in a basket of securities. Some of the most-commonly referenced ETFs simply track the S&P 500 or other broad indices. These are known as index funds or index ETFs.

Unlike mutual funds, ETFs are traded on public exchanges similar to a stock. This makes ETFs easier to access and more liquid, generally speaking, than mutual funds.

Historically, ETFs have featured a more passive management approach than mutual funds. Some ETFs are controlled by algorithms designed to mimic indices or market movement, leading to lower expense ratios than mutual funds with similar investment goals. 

Over time, however, the ETF industry grew to include many actively-managed funds (similar to mutual funds in design). As such, it’s important to recognize the more structural differences between ETFs and mutual funds.

How are mutual funds and ETFs different?

Two columns showcase how mutual funds (on the left) compare to ETFs (on the right). 1 - Mutual funds tend to be actively managed by a fund manager, ,even when the investment goal is simple, like tracking an index. ETFs can be active or passively managed. Many passive ETFs are used by investment professionals (like a financial advisor) when implementing an active strategy. 2 - You can only buy into or exit a mutual fund one per day: all investors buying into the fund on that day pay the same price. Investors can buy or sell ETFs whenever the host stock exchanges is open; the market dictates the cost of the shares. 3 - Mutual funds include various fees; some come with upfront load fees, early redemption fees, plus management fees and fees tied to other operating expenses. The fund prospectus should include a breakdown. ETFs may include management and operating expenses (included in the net expense ratio). You may also pay trading commissions or other transaction costs when buying and selling shares of an ETF. 4 - When a fund manager sells investments within a mutual fund, it may trigger a capital gain or loss that is passed on to shareholders. Since these apply to individual securities within the fund, you may incur capital gains even if the fund itself loses value. ETFs tend to use in-kind transactions to avoid triggering capital gains tax. Additionally, since most ETFs are traded as a secondary market, it's uncommon for capital gains generated within the fund to be passed on to shareholders.

How to decide between mutual funds and ETFs?

At Revo FInancial, we tend to use passively-managed ETFs that track a particular asset class. For instance, we might select a fund that mirrors small-cap stocks or U.S. Treasuries.

This allows us to be more active with our management strategies; we can tailor your portfolio to current market conditions and your goals. We find this works better than a portfolio manager making active investment decisions, since those decisions are designed for a collective goal, and aren’t personalized to you. 

That said, we know many 401(k)s offer mutual funds as their primary investment vehicle, and these funds can be a great tool to help you save for retirement. It’s important to understand the fund’s investment objectives and fees—this will tell you how funds will be managed in various market conditions, and how fees may impact your potential returns.

At Revo, we can consult with you on your workplace 401(k) by reviewing the various fund options and discussing how those mutual funds align with the rest of your investment portfolio. Our goal is to look at your whole financial picture, including the assets in your workplace retirement account, and we’re happy to walk you through any questions you may have about the mutual funds offered by your plan sponsor.

If you have additional questions about how mutual funds or ETFs work, or how they apply to you and your portfolio, contact us to discuss.