Mutual Funds vs ETFs: Understanding the Difference

Mutual funds and ETFs both let you own hundreds (or thousands) of stocks in a single investment. But they have important differences that affect how you invest and what you pay. Here's what you need to know.

What They Have in Common

Both mutual funds and ETFs are:

• Baskets of investments (stocks, bonds, or both)
• Professionally managed (or track an index)
• Diversified by design
• Available in your 401(k) or brokerage account

They both solve the same problem: letting you invest broadly without picking individual stocks.

Key Differences

ETFs: How They Work

ETFs trade on stock exchanges like individual stocks. You buy and sell at market prices throughout the day.

Pros:

• Buy any amount (with fractional shares)
• Lower expense ratios on average
• More tax-efficient
• See real-time prices

Cons:

• May need to buy whole shares (without fractional)
• Can have bid-ask spreads
• No automatic purchases at most brokerages

Best for: Taxable brokerage accounts, flexibility, cost-conscious investors

Mutual Funds: How They Work

Mutual funds calculate their value once per day after the market closes. All orders execute at that price.

Pros:

• Easy automatic investing (set up recurring purchases)
• No bid-ask spreads
• Can invest exact dollar amounts

Cons:

• Often higher minimum investments
• Less tax-efficient
• Can't trade intraday (doesn't matter for long-term investors)

Best for: 401(k)s, automatic investment plans, simplicity

Expense Ratios: The Cost That Matters Most

Both charge annual fees called expense ratios. This is a percentage of your investment, deducted automatically.

Example with $10,000 invested:

• 0.03% expense ratio (low-cost ETF): $3/year
• 0.50% expense ratio (average mutual fund): $50/year
• 1.00% expense ratio (expensive fund): $100/year

Good expense ratios:

• Index funds: Under 0.10%
• Actively managed: Under 0.50%
• Avoid: Anything over 1% without extraordinary reason

Index vs. Actively Managed

This distinction matters more than ETF vs. mutual fund:

Index Funds (Passive)

Track a market index like the S&P 500

• Very low costs (0.03%-0.10%)
• Match market returns
• Most professional investors fail to beat them long-term

Actively Managed Funds

Fund managers try to beat the market

• Higher costs (0.50%-1.50%+)
• Most underperform index funds over time
• A few do add value, but hard to identify in advance

Tax Efficiency (Taxable Accounts Only)

In tax-advantaged accounts (401k, IRA), this doesn't matter. But in taxable accounts:

ETFs are more tax-efficient because:

• Their structure creates fewer "taxable events"
• You control when to realize gains (when you sell)

Mutual funds may trigger taxes when:

• Other investors sell shares (forcing the fund to sell holdings)
• The fund rebalances
• You didn't sell anything but still owe taxes

For taxable accounts, ETFs or "tax-managed" mutual funds are better.

What to Choose Where

In Your 401(k)

Usually limited to mutual funds. That's fine—choose the lowest-cost index funds available.

In Your IRA

Either works. Many prefer ETFs for slightly lower costs, but mutual funds are fine if you prefer automatic investing.

In Taxable Brokerage Accounts

ETFs are generally better for tax efficiency. Use tax-efficient funds like total market index.

Popular Funds to Know

Total US Stock Market:

• ETF: VTI (Vanguard), ITOT (iShares) - ~0.03%
• Mutual Fund: VTSAX (Vanguard) - 0.04%

S&P 500:

• ETF: VOO (Vanguard), SPY, IVV - ~0.03%
• Mutual Fund: VFIAX (Vanguard) - 0.04%

Total Bond Market:

• ETF: BND (Vanguard), AGG (iShares)
• Mutual Fund: VBTLX (Vanguard)

The Bottom Line

The ETF vs. mutual fund debate matters less than: (1) keeping costs low, (2) staying diversified, and (3) investing consistently. Choose low-cost index funds in either format, and you'll do great.