When faced with a choice between buying shares in an exchange-traded fund (ETF) and buying shares in a mutual fund that follows a similar strategy, which is the better option for you?
“The choice isn’t always black and white,” says Charles Rotblut, with AAII, which helps individual investors. The answer may depend on several factors, including how you typically trade investments and in what type of account you plan to hold the asset.
ETFs and mutual funds have much in common. Both are easy to trade and offer diversified exposure to a swath of the market in one go. They both pool assets from shareholders and invest in diversified baskets of stocks, bonds or other assets. There are actively managed and index-based strategies in both ETF and mutual fund structures.
But there are key differences too. When you buy or sell mutual fund shares, trades are executed once a day, after the market closes. You may pay a transaction fee to buy shares in a mutual fund. But you can buy or sell ETFs throughout the trading day just as you would a stock, and they trade commission-free at most brokerage firms. ETF share prices fluctuate throughout the day, and there is a bid-ask spread—the difference between the highest price a buyer is willing to pay for an asset and the lowest price that a seller is willing to accept. What’s more, an ETF’s share price may deviate from its net asset value—the actual value per share of its underlying holdings—during the trading day.
But it doesn’t have to be an either-or decision. “ETFs are better in most situations because they are more tax efficient and generally less costly—there are no transaction fees,” says Thomas Stapp, a certified financial planner in Olympia, Washington. But he invests in mutual funds, too, particularly when he finds a strategy that is “notably better than any ETF option” or when a strategy isn’t available in an ETF.
Consider the investing scenarios below to see which fund structure works best in certain circumstances.
You want to make regular, automated investments. A mutual fund works better if you want to set up regular contributions to a brokerage account, says Molly Concannon, head of equity products at Vanguard. You can’t get that service with ETFs, she says. “It’s limited to mutual funds.”
You have less than $1,000 to invest. Outside of a retirement plan—you’re investing on your own at a brokerage firm, say—you’re better off with an ETF if you only have small sums to invest. That’s because the minimum investment for most retail mutual funds is more than $1,000, but you can buy ETFs for as little as the price of one share.
You’re investing in a taxable account and you’re tax wary. Go with an ETF. Tax efficiency has long been a draw for investors to ETFs. It has to do with the way that ETFs are structured compared with mutual funds.
You’re investing in a tax-deferred account. Opt for whichever is cheaper in annual expense ratio plus any transaction fees.
You’re an active trader. ETFs are nimbler than mutual funds because they trade intraday. Mutual fund trades settle once a day, after the market closes.
(Nellie S. Huang is senior associate editor at Kiplinger’s Personal Finance magazine. For more on this and similar money topics, visit Kiplinger.com.)
