Mutual Funds vs. ETFs: Key Differences

Coke versus Pepsi. McDonalds versus Burger King. Apple versus Android. You’re probably familiar with many similar products that compete for your money, attention, and loyalty. In the financial world, it’s no different.

Consider mutual funds versus ETFs. They’re both widespread, easy-to-access investment vehicles that can help you achieve instant diversification. Yet they have a few striking differences that informed investors should be aware of.

We’ll unravel their distinctive characteristics, detailing what sets ETFs and mutual funds apart. Soon, you’ll better understand which product aligns best with your goals. As a bonus, you’ll be better prepared for a side-by-side mutual fund comparison and understand how to evaluate ETFs.

Understanding mutual funds

Want to understand how popular mutual funds are? As of 2022, mutual funds registered in the U.S. held more than $22 trillion in assets under management, representing triple-digit AUM growth from the 1990s.

In short, mutual funds are one of the most popular investment products. It stands to reason; mutual funds allow individuals to pool their money and access diversified portfolios of stocks, bonds, and other assets, with fund managers leading the charge and deciding the best underlying assets to buy.

That’s important to note: Mutual funds are “actively managed.” Somebody’s in control of their day-to-day operations. Their job is to achieve growth while preserving investors’ capital. 

However, this active management comes at a cost, with mutual fund fees typically ranging from 2–5%, with additional fees occasionally charged on top (examples include “12b-1” fees and “front-end loads”). 

This means mutual funds are a relatively expensive option. What’s more, active managers tend to underperform average market returns as well as index funds. Who’s eager to pay more for worse?

Common as they are, mutual funds may not always be the best option, especially for more sophisticated investors. For those investors who prefer active management, however, it can be best to compare mutual funds, selecting those with the lowest fees and strongest past performance. 

Understanding exchange-traded funds (ETFs)

Exchange-traded funds (ETFs) have a relatively short but impactful history. The first ETF, the SPDR S&P 500 ETF Trust (SPY), was introduced in 1993. It aimed to provide investors with a low-cost, flexible, and tradable alternative to mutual funds. Since then, the ETF category has exploded, and for all the reasons you might guess. 

Like mutual funds, ETFs provide a versatile and user-friendly approach to investing in diverse assets, such as stocks or bonds, without purchasing each individually. But ETFs also trade just like stocks, meaning you can buy and sell shares during regular market hours, any time between open and market close, in essentially any brokerage account.

ETFs truly offer the best of both worlds: the diversity of a mutual fund and the tradability, flexibility, and relative liquidity of a stock. You’re not locked into an arbitrary timeframe or a minimum investment amount.

ETFs also boast significantly cheaper expense ratios than mutual funds because few are “actively managed.” Instead, most ETFs resemble index funds in that they are passively managed — designed to track a market index or sector.

All these attributes make ETFs an appealing option for individuals seeking to spread their investments across a broad spectrum while minimizing fees and potentially maximizing returns.

ETF investors can compare ETFs inside Composer’s comprehensive ETF database. 

What ETFs and mutual funds have in common 

Before we explain their differences, let’s review what mutual funds and ETFs have in common: 

Diversification

Both ETFs and mutual funds provide diversification without purchasing dozens or hundreds of individual stocks or bonds. Instead, investors can simply buy shares of the fund.

Lower risk

Both products are generally considered lower risk, especially compared to investing directly in individual stocks. Because they offer diversification across various assets, the risk is spread out, reducing the impact of any single security with poor performance. 

Liquidity

ETFs and mutual funds offer a relatively high degree of liquidity, allowing you to buy and sell your shares. This flexibility enables investors to quickly adjust their portfolios and access their funds.

Professional management

In the case of mutual funds and actively managed ETFs, your money is managed by professional portfolio managers who make investment decisions on your behalf. These experts are responsible for selecting and adjusting the fund’s underlying assets to align with the fund’s objectives. (Keep in mind that not all ETFs are actively managed.) 

Differences between mutual funds and ETFs

Now, let’s delve into what sets these two investments apart: 

Costs

One of the most noticeable distinctions is the cost structure. ETFs typically have significantly lower expense ratios compared to mutual funds. Since ETFs often passively track an index, they tend to have lower management fees. They also tend to minimize capital gains, helping reduce your tax burden. These cost advantages can result in higher net returns for ETF investors. 

Minimum investments

ETFs are known for their accessibility. They usually have no minimum investment requirements, meaning investors can start with as little as the price of a single share. This makes them an attractive choice for beginners or those with limited funds.

On the other hand, mutual funds may have minimum investment thresholds, sometimes ranging from hundreds to thousands of dollars. This requirement can be a barrier for investors with less capital. 

Structure

The structural differences between these investment vehicles are significant. 

ETFs are structured as open-end investment companies but employ a unique creation and redemption process involving authorized participants (usually large financial institutions).

These authorized participants facilitate the creation or redemption of ETF shares in the secondary market. This creation/redemption process helps ETFs maintain price close to their net asset value (NAV).

In contrast, mutual funds operate as open-end investment companies, and they issue or redeem shares directly with the fund company at the end of each trading day based on the NAV. This daily pricing and transaction process can lead to differences between the market price and the NAV for mutual funds, creating arbitrage opportunities.

These distinctions in cost, minimum investments, and structure can and should influence investors’ choices. ETFs are often favored for their cost-efficiency and flexibility, while mutual funds may appeal to investors who are less comfortable making buy-and-sell decisions and prefer active management. 

Feeling torn between ETFs and mutual funds? Let Composer be your compass in the investment world.

With Composer, you have the flexibility to invest directly in ETFs. Our comprehensive ETF database lets you sift and choose according to various active, passive, leveraged, and otherwise diversified ETFs.

But that’s just the beginning. With Composer, you can also access pre-programmed trading algorithms and utilize our user-friendly tools to create your own strategies—no coding skills required. 

In fact, our ChatGPT-4-powered tech means you can set goals using simple, natural language. AI simplifies the process and helps you make informed investment decisions with confidence.

Join our platform today to supercharge your investing and explore the countless possibilities the world of ETFs and algorithms has to offer. 

And don’t forget, Composer also offers a thriving community database of more than 1,000 stock trading algorithms, all based on ETFs. So, if you’re seeking inspiration, you’ll find a wealth of resources at your fingertips. Start exploring now!