What is the Difference Between an ETF and a Mutual Fund?

Felicia Dye

There are many differences between an ETF and a mutual fund that may prompt a person to choose one over the other. Mutual funds generally subject investors to higher costs in the form of management fees and capital gains tax. It is also important to note that, due to hefty minimum investments, mutual funds may not be accessible to everyone. Furthermore, because ETFs are listed on stock exchanges, they offer more trade flexibility.

Capital gains tax can apply to an ETF, but the costs on average are much lower than those for an actively managed mutual fund.
Capital gains tax can apply to an ETF, but the costs on average are much lower than those for an actively managed mutual fund.

When comparing the possibility of investing in an ETF and a mutual fund, people often look for a solid answer of which is the best type of investment overall. Unfortunately, it is often not feasible to provide a clear-cut answer of that sort. Both types of investments have the potential to do well or poorly, so it is best to understand the differences between them and then to make choices on an individual basis.

Although most ETFs are passively managed index funds, in 2008 the U.S. Securities and Exchange Commission (SEC) approved the development of the first actively managed ETF.
Although most ETFs are passively managed index funds, in 2008 the U.S. Securities and Exchange Commission (SEC) approved the development of the first actively managed ETF.

To begin with, it is important to understand there are two types of mutual funds: active and passive. An actively managed mutual fund is the type that most individuals consider when making a comparison to ETFs. These funds are actively managed by a portfolio manager or an entire team of managers, meaning that professionals are regularly working to help investors profit. This also means that there are generally significant management fees, which contribute to the fact that the costs associated with a mutual fund are often higher than those associated with an ETF.

Another cost issue that arises in a comparison of an ETF and a mutual fund is taxes. In general, ETFs are subject to much lower taxes. Mutual funds usually subject investors to significantly higher capital gains tax, even if the investors do not sell any shares. Capital gains tax can also apply to an ETF, but the costs on average are much lower.

One characteristic that may be viewed positively by some is that ETFs are usually more accessible to people with less money to invest. These investment vehicles generally have no minimums. On the contrary, mutual funds often require a hefty initial minimum investment. For some, however, this may be viewed as an advantage because it makes this investment option more exclusive. Furthermore, some investment professionals suggest that shares in a mutual fund can offer the possibility of substantially higher gains than those in an ETF.

Trading flexibility is worthy of consideration when comparing and ETF and a mutual fund. ETFs are traded on stock exchanges. This means that they can be purchased and sold all day at varying prices. Mutual funds are not listed on stock exchanges, and their price is set at the end of the day based on their net asset value (NAV). The sale and purchase of shares is limited to one time during the day.

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