ETFs vs Mutual Funds
ETFs (Exchange-Traded Funds) and mutual funds both pool investor money to buy a diversified basket of securities. They are more alike than different, but the differences matter — especially regarding fees, tax efficiency, and how you buy them.
Key Differences
- Trading — ETFs trade like stocks throughout the day at market price. Mutual funds trade once per day at the closing NAV. For long-term investors, this difference is irrelevant
- Minimum investment — ETFs: price of one share (or $1 with fractional shares). Mutual funds: $0-$3,000 depending on the fund company
- Expense ratios — ETFs tend to be slightly cheaper. Vanguard VOO (ETF): 0.03%. Vanguard VFIAX (mutual fund): 0.04%. The difference is negligible
- Tax efficiency — ETFs are more tax-efficient in taxable accounts due to their creation/redemption mechanism that minimizes capital gains distributions. In retirement accounts (401k, IRA), this advantage disappears
- Automatic investing — Mutual funds allow automatic fixed-dollar investments ($500/month). ETFs require buying whole shares (or fractional where supported). Mutual funds win for automated investing
- Dividend reinvestment — Both offer DRIP, but mutual funds handle it more seamlessly
Which to Choose
- In a 401(k) — You are limited to what your plan offers, usually mutual funds. Choose the lowest-cost index fund available
- In an IRA — Either works. Mutual funds if you want seamless automatic investing. ETFs if you want slightly lower costs
- In a taxable brokerage — ETFs are slightly better due to tax efficiency
- Bottom line — The difference between a low-cost ETF and a low-cost mutual fund tracking the same index is trivial. Pick one and invest consistently. Do not let this decision delay your investing