ETFs and mutual funds may seem very similar, but there are numerous differences. ETF stands for exchange-traded funds. A mutual fund is an investment company that pools money from investors to purchase securities that the investors cannot purchase individually at a fair price. The SEC lists ten differences between these two types of assets.
ETFs trade openly throughout the day as they are bought and sold on exchanges like NYSE or NASDAQ. In contrast, mutual funds trade only once per day after their net asset value is calculated overnight by the fund’s administrator. Fund companies calculate NAV based on complex mathematical formulas that account for portfolio holdings, stock prices, market interest rates, dollar amounts invested into the fund etc. Mutual funds usually buy securities of well-known corporations since no one would invest in a fund that invests in small unknown companies.
ETFs are more liquid than mutual funds since you can buy or sell any time during the trading day when the market is open.
When you can buy or sell them
Investors can purchase ETF shares directly from an ETF without paying sales commissions while they have to go through their fund’s administrator for Mutual Funds, who will charge them a fee for buying shares. On the other hand, because there are no sales commissions, ETF investors may pay slightly lower annual expenses than mutual funds investors, who also incur commission costs when purchasing Fund shares.
ETFs are traded like stocks on exchanges, and thus you buy these securities once per day at the closing price or the end of the day’s most recent market activity. Mutual Funds are only traded once per day, with net asset value calculated after the market closes, meaning you can purchase these securities anytime during the trading day.
Dividends paid and capital gains distributions
ETFs distribute dividends daily to shareholders within a few days of receiving them from companies they invest in. This means that ETF investors receive the total amount of investment income distributions without any deductions for fees. In contrast, mutual fund investors do not receive dividend and capital gains distributions directly but rather through their fund’s administrator, who allocates such amounts among all investors and charges an additional fee for doing so. The downside to this practice is that if your mutual fund invests in several securities, it may not distribute dividends and capital gains to you as quickly as the underlying stocks pay them out.
ETFs simply pass through all dividends and capital gains to individual investors without any deduction for fees or expenses and do so daily, meaning mutual fund companies deducts fees and shares withheld before distributions. ETF shareholders typically receive net asset value (NAV) per share plus part of the income distribution minus sales charges within a few days of purchase. Mutual fund company administrators will then take those funds that they withheld from those distributions and divide them among all shareholders and charge an additional fee for doing so, which reduces each shareholder’s own returns by a small amount.
ETF funds are passively managed and track a benchmark index by holding all of the securities in that index in the same proportion as they exist in that market basket. On the other hand, mutual funds are actively managed, and the fund manager invests in various combinations of securities (which may include derivatives such as futures) which they think will outperform a given index. Thus investors’ returns depend to a great extent on the skills of their managers and their ability to predict market movements.
ETFs typically offer lower operating expenses than mutual funds due to passive management styles that do not include paying additional fees to an active portfolio manager.
ETFs generally qualify for one type of tax treatment called “passive foreign investment company” (PFIC) status. At the same time, mutual funds typically do not receive this special tax treatment because there are many factors involved.
The only thing management decides is which companies to buy and sell based on present valuations and potential gains. Therefore these investments do not require frequent trading, and it is expected to be more tax-efficient than actively managed mutual funds. Meanwhile, mutual funds may be either actively or passively managed: Actively Managed Mutual Funds invest money into securities chosen by their portfolio manager, who analyzes current market conditions and makes decisions.