ETFs vs Mutual Funds: What's the Difference?

What Are ETFs and Mutual Funds?

Both ETFs (exchange-traded funds) and mutual funds pool money from multiple investors to buy a basket of stocks, bonds, or other securities. The key difference? How they trade and operate.

An ETF is a fund that trades on an exchange like a stock. When you buy an ETF, you're purchasing shares in a fund that holds hundreds or thousands of underlying securities. The SPY (SPDR S&P 500 ETF), for example, holds all 500 stocks in the S&P 500 in a single tradable security.

A mutual fund is a professionally managed investment company that pools investor money and buys securities according to a stated objective. Unlike ETFs, mutual fund shares are priced and traded only once per day, after the market closes at 4 p.m. ET.

Historical Context

Mutual funds dominated for decades—the first one launched in 1924. ETFs arrived in 1993 with the SPY, which revolutionized how people access diversified portfolios. Today, the global ETF market exceeds $13 trillion in assets, with ETFs growing faster than mutual funds since 2015.

Trading: Intraday Flexibility vs. Daily Pricing

How ETFs Trade

ETFs trade during market hours (9:30 a.m. to 4:00 p.m. ET on U.S. stock exchanges). You can buy and sell shares at any time throughout the day, with prices fluctuating based on supply and demand—just like individual stocks.

Example: You want exposure to the technology sector. You buy 100 shares of QQQ (Invesco QQQ Trust, which tracks the Nasdaq-100) at 10:15 a.m. for $385 per share ($38,500 total). Two hours later, the market has moved, and QQQ trades at $387. You can sell all 100 shares immediately if you wish, locking in your $200 gain.

How Mutual Funds Trade

Mutual fund shares are priced once daily at the Net Asset Value (NAV), which is calculated after markets close. If you place an order to buy or sell mutual fund shares at 2 p.m., your transaction executes at that day's closing NAV—you won't know the exact price until 4 p.m.

Example: You order 100 shares of Vanguard 500 Index Fund (VFIAX) at 1:30 p.m. with an NAV of $265. Markets close, the NAV is calculated as $264.50. Your purchase executes at $264.50 per share ($26,450 total), not the $265 you saw when ordering.

What This Means for Your Portfolio

If you trade actively or need quick exits: ETFs win. Intraday pricing lets you respond to market moves in real-time. If the Fed announces a surprise rate hike and you want out of growth stocks, you sell your QQQ immediately.

If you invest passively and hold long-term: The difference is negligible. Once-daily pricing for mutual funds makes no practical difference if you're buying and holding for 10+ years.

Costs: Expense Ratios and Trading Fees

Expense Ratios Explained

The expense ratio is the annual cost of owning a fund, expressed as a percentage of assets. It covers management fees, administrative costs, and distribution expenses.

ETFs typically charge 0.03% to 0.50% annually. The SPY costs 0.09%—meaning on a $100,000 position, you pay $90 per year. Mutual funds average 0.50% to 2.00%+ depending on whether they're actively or passively managed.

Over 20 years, that difference compounds. A $100,000 position in a 0.10% ETF versus a 1.00% mutual fund costs $18,000 less in fees (assuming 7% annual returns and fees deducted from principal).

Trading Commissions

Most brokers (Fidelity, Schwab, TD Ameritrade) now offer commission-free trading on both ETFs and mutual funds. However, some brokers still charge trading fees on certain mutual funds, particularly load funds that compensate sales professionals.

A load fund charges a front-end fee (typically 3% to 6%) when you buy. If you invest $10,000 in a 5% load fund, $500 goes to the broker and only $9,500 buys fund shares. This is separate from the expense ratio.

Minimums

Many mutual funds require minimum initial investments: $1,000, $3,000, or even $25,000 for institutional share classes. ETFs have no minimum—you can buy a single share. If Berkshire Hathaway's B shares (BRK.B) trade at $390, you can invest $390.

Tax Efficiency: A Major Advantage for ETFs

How ETFs Minimize Taxes

ETFs use a creation/redemption mechanism that reduces capital gains distributions. When fund shares are redeemed, ETF managers can select which securities to deliver to the redeeming investor—typically the lowest-cost-basis shares. This keeps high-gain securities in the fund, reducing taxable distributions to remaining shareholders.

Mutual funds, lacking this mechanism, must sell securities when investors redeem shares. If the fund holds winners, those sales trigger capital gains that are distributed to all shareholders—even those who didn't redeem.

Real Example

Consider a fund holding two stocks: Stock A (purchased at $20, now $50) and Stock B (purchased at $40, now $50). An investor redeems $1 million of fund shares.

ETF approach: Manager delivers Stock B shares (lowest gains) to the redeeming investor. The $30 gain stays in the fund's books. Remaining shareholders avoid the capital gains tax.

Mutual fund approach: Manager sells some of both stocks to raise $1 million. The $30 gain on Stock A is realized and distributed to all shareholders as taxable income. Shareholders who didn't redeem still owe taxes on gains they never received in cash.

The Numbers

Research by Vanguard found that over a 20-year period, an ETF and an identical-index mutual fund had similar gross returns. But after taxes, the ETF significantly outperformed in taxable accounts. A $10,000 investment in a low-cost S&P 500 mutual fund grew to $49,700 after taxes, while the same in an ETF grew to $52,100—a $2,400 difference on 0% additional performance.

This advantage matters most for investors in taxable accounts (not retirement accounts). If you hold the funds in a 401(k) or traditional IRA, taxes are deferred anyway, so the ETF advantage disappears.

Management Style: Active vs. Passive

Passive Funds (Index Funds)

Passive funds track an index like the S&P 500 or NASDAQ-100. The manager simply holds the securities in the index, rebalancing when the index changes. Costs are low because minimal active decision-making is required.

Both ETFs and mutual funds offer passive options. The Vanguard S&P 500 ETF (VOO) and Vanguard 500 Index Fund (VFIAX) track the same index with nearly identical results. VOO charges 0.03%; VFIAX charges 0.04%.

Active Funds

Active funds employ managers to select individual securities, attempting to beat their benchmark. Active mutual funds outnumber active ETFs, though active ETFs are growing rapidly.

Active funds' higher costs (0.50% to 2.00%+) reflect manager salaries and research expenses. The challenge: most active managers underperform their benchmarks after fees. Morningstar data shows that 85% of active stock funds underperform the S&P 500 over 15-year periods.

Comparison Table: ETFs vs Mutual Funds

Common Mistakes and Pitfalls to Avoid

Mistake #1: Assuming ETFs Are Always Cheaper

While passive ETFs typically have lower fees than active mutual funds, active ETFs can cost as much or more. An active stock ETF might charge 0.60% while a passive mutual fund charges 0.20%. Always compare the specific expense ratio, not just the fund type.

Mistake #2: Trading ETFs Like Stocks

Intraday trading access doesn't mean you should use it. Frequent trading generates short-term capital gains (taxed at ordinary income rates, up to 37%), incurs bid-ask spreads, and rarely beats buy-and-hold. A $100,000 ETF position traded 10 times per year at a 0.10% bid-ask spread costs $1,000 annually in hidden fees—erasing years of low expense ratio savings.

Mistake #3: Ignoring Bid-Ask Spreads on Illiquid ETFs

Popular ETFs like SPY have tight spreads—often $0.01 between bid and ask. Niche ETFs (sector rotations, emerging market bonds) can have spreads of 0.50% or more. If you're buying an illiquid ETF, you're paying that spread as a hidden trading cost. Always check the spread before investing.

Mistake #4: Choosing Mutual Funds Based on Past Performance Alone

A mutual fund that returned 15% last year might underperform next year. The manager who achieved those returns might have left. Past performance does not guarantee future results. Focus on expense ratio, fund philosophy, and manager tenure instead.

Mistake #5: Not Accounting for Taxes in Taxable Accounts

An active mutual fund returning 9% after taxes might underperform a passive ETF returning 7% after taxes. If you're in a high tax bracket, the ETF's tax efficiency can add 1% to 2% annually. For taxable accounts, lean toward ETFs unless you have a compelling reason for a mutual fund.

Which Should You Choose?

Choose ETFs If You:

• Want to invest a small amount with no minimums
• Trade actively or need quick exits
• Invest in a taxable account (brokerage, not retirement)
• Prefer daily transparency and real-time pricing
• Want lower fees for passive index investing

Choose Mutual Funds If You:

• Invest exclusively in tax-advantaged retirement accounts (401(k), IRA) where tax efficiency doesn't matter
• Prefer automatic monthly investing through payroll contributions
• Want fractional share investing (many mutual funds allow it; not all ETFs do)
• Have found an exceptional active manager with a long track record and reasonable fees
• Need a minimum investment to qualify for institutional share classes with lower fees

For Most Investors

The optimal strategy combines both. Use low-cost passive ETFs (VOO for U.S. stocks, VXUS for international, BND for bonds) as your core holdings in taxable accounts. Use mutual funds for tax-advantaged retirement accounts if your 401(k) or IRA plan offers them with no expense advantage. This captures tax efficiency where it matters most—taxable accounts—while simplifying your portfolio.

Real-World Example: Building a Diversified Portfolio

Scenario: $100,000 to invest, age 35, moderate risk, taxable brokerage account

ETF Portfolio:

• $50,000 in VOO (Vanguard S&P 500 ETF, 0.03% expense ratio) = $15 annual fee
• $20,000 in VXUS (Vanguard Total International Stock ETF, 0.08%) = $16 annual fee
• $20,000 in BND (Vanguard Total Bond Market ETF, 0.03%) = $6 annual fee
• Total annual fees: $37

Comparable Mutual Fund Portfolio:

• $50,000 in VFIAX (Vanguard 500 Index Fund, 0.04%) = $20 annual fee
• $20,000 in VTIAX (Vanguard Total Intl Stock Index Fund, 0.11%) = $22 annual fee
• $20,000 in VBTLX (Vanguard Total Bond Market Index Fund, 0.05%) = $10 annual fee
• Total annual fees: $52

Annual savings: $15. Over 30 years with 7% returns, that $15 annual difference compounds to roughly $1,500 in additional wealth. The real advantage emerges if you hold in taxable account and ETF's tax efficiency adds 0.5% to 1.0% annually—a $500 to $1,000 annual difference.

Frequently Asked Questions

Q: Can you hold ETFs in a retirement account like an IRA?

Yes. ETFs are eligible for IRAs, 401(k)s, and other tax-advantaged accounts. However, in these accounts, the tax advantages that make ETFs attractive in taxable accounts don't apply—taxes are deferred anyway. Choose based on fees and fund selection, not tax efficiency.

Q: Do ETFs pay dividends like stocks?

ETFs hold stocks and bonds that pay dividends and interest. These distributions flow to ETF shareholders. You can reinvest dividends automatically or take them as cash. Dividend-focused ETFs like SCHD (Schwab U.S. Dividend Equity ETF) specifically target high-dividend stocks.

Q: What's the bid-ask spread, and why does it matter?

The bid-ask spread is the difference between the highest price a buyer offers and the lowest price a seller asks. SPY's spread is typically $0.01 (bid $445.50, ask $445.51). When you buy, you pay the ask; when you sell, you receive the bid. Illiquid ETFs can have spreads of 0.50% or more. This is a hidden trading cost—if you buy and sell frequently, it adds up.

Q: Are ETFs safer than mutual funds?

Both are equally safe investor protection. Neither can disappear with your money. Diversification reduces single-security risk. However, both can lose value if markets fall. A technology-heavy ETF drops alongside tech stocks. Safety depends on what you own, not whether it's an ETF or mutual fund.

Q: Can you short an ETF or use leverage?

Yes, with margin accounts. You can short-sell ETFs like stocks and use inverse ETFs (-1x leverage) or leveraged ETFs (2x or 3x leverage) for directional bets. However, leveraged ETFs experience decay—they don't track their underlying index perfectly over time. Inverse and leveraged ETFs are trading tools, not long-term investments. Most retail investors should avoid them.

Q: What happens if an ETF is liquidated or shut down?

If an ETF closes, the fund manager liquidates holdings and returns cash to shareholders, typically within a few weeks. This is rare with established ETFs but happens with niche or underperforming products. You may realize capital gains in a taxable account when this occurs. Stick to ETFs with significant assets ($100 million+) to minimize this risk.

Key Metrics to Compare When Choosing

Expense Ratio: Lower is better, but only compare funds with identical mandates. A 0.20% bond ETF outperforms a 0.05% stock ETF? That's comparing apples to oranges.

Assets Under Management (AUM): Larger funds (above $100 million) are less likely to close and typically have tighter bid-ask spreads. However, massive size doesn't necessarily mean better returns.

Tracking Error: For index funds, this measures how closely the fund tracks its benchmark. Lower is better. If the S&P 500 returns 10% and your S&P 500 fund returns 9.85%, tracking error is 0.15%—likely due to fees and minor cash drag.

Dividend Yield: If holding for income, compare dividend yields. VOO yields around 1.5%, while SCHD yields 3%+. Higher yield means more cash income from dividends, though yields fluctuate with stock prices.

Next Steps: Building Your ETF/Mutual Fund Strategy

Step 1: Assess your account type. Taxable brokerage? Choose ETFs. Tax-advantaged 401(k)? Mutual funds are fine; focus on expense ratios.

Step 2: Define your asset allocation. How much stock vs. bonds? Domestic vs. international? This drives fund selection more than ETF vs. mutual fund.

Step 3: Compare expense ratios for your specific fund selection. Don't just assume ETFs are cheaper—compare the exact funds you're considering.

Step 4: Evaluate liquidity and bid-ask spreads if trading frequently. Most buy-and-hold investors can ignore this, but active traders should check spreads on niche ETFs.

Step 5: Set up automated investments. Whether ETF or mutual fund, consistency beats timing. Monthly investments smooth out volatility and remove emotion.

This article is part of Ticker Daily's complete how to trade and invest in ETFs guide. For deeper dives into specific ETF strategies, explore our full learning hub.