Mutual Funds vs. ETFs

Why this matters

For many people, a fund is their first investment, often their only one, and sometimes chosen automatically inside a workplace retirement plan. Funds make it possible to own hundreds or thousands of companies with a single purchase. Knowing the two main kinds helps you understand what you're buying, how you buy it, and what it costs.

What a fund is

A fund pools money from many investors and uses it to buy a collection of investments, such as stocks, bonds, or both. Each investor owns shares of the fund, and so owns a slice of everything it holds. Funds offer three main benefits:

• Diversification in one purchase, which Risk and Return showed can reduce the damage from any single company.
• Professional management, whether that means choosing investments or simply following an index.
• Small amounts buy a share of a large, spread-out portfolio.

How a fund's share is valued

A fund's net asset value, or NAV, is its total assets minus its liabilities. Divide that by the number of fund shares, and you get the value of one share. A fund with $100 million in net assets and 10 million shares has a NAV of $10 per share.¹

Mutual funds

With a mutual fund, you buy shares from the fund and sell them back to it. Mutual funds must calculate their NAV at least once every business day, typically after the major US exchanges close, and every buy and sell order is filled at the next NAV calculated after the order is placed. So if you place an order during the day, you won't know your exact price until that evening.¹

Exchange-traded funds

An ETF is also a fund, but its shares trade on a stock exchange throughout the day at market prices, just like a stock.² You buy them from, and sell them to, other investors through your broker, using the same order types you learned in Order Types: Market, Limit, and Stop.

Because the price is set by trading, an ETF can trade slightly above or below the value of its holdings, at a premium or discount. Large firms called authorized participants can trade directly with the ETF at NAV, and they profit by closing any gap, which generally keeps the market price close to NAV.²

At 11 a.m. on a Tuesday, Priya decides to put $1,000 into a fund that tracks a broad stock index. The fictional fund comes in both forms.

	Mutual fund version	ETF version
When the order fills	After the market closes, at Tuesday's NAV	Within seconds, at the market price
Price known when ordering?	No	Approximately, from the bid and ask
Buying exactly $1,000	Usually possible, since mutual funds deal in partial shares	Possible if her broker offers fractional shares

For a long-term investor, the timing difference rarely matters: both orders end up invested on the same day, in the same investments.

Costs

Both mutual funds and ETFs charge an expense ratio, a yearly percentage of your investment that pays the fund's operating costs.³ Beyond that, the costs differ:

• Some mutual funds charge a sales load when you buy or sell, typically to compensate the broker who sold them, and some charge 12b-1 fees for marketing and distribution. 12b-1 fees typically apply to mutual funds, not ETFs.³
• ETFs are bought and sold at market prices, so you pay the bid-ask spread, and any commission your broker charges.

FINRA's free Fund Analyzer lets you compare the long-term effect of fees for up to three funds at a time.⁴

Taxes

When a fund sells investments at a profit, it generally passes those gains to shareholders as a capital gains distribution. In a taxable account, those distributions are generally taxable, even if you never sold a share yourself. Because many ETFs exchange securities "in kind" with authorized participants instead of selling them for cash, ETFs typically make fewer capital gains distributions than mutual funds. In a tax-advantaged account, such as a 401(k) or IRA, there's no tax difference between the two.⁵

Key takeaways

• A fund pools investors' money to buy a diversified collection of investments.
• Mutual funds trade once a day at NAV. ETFs trade all day on exchanges at prices close to NAV.
• Both charge expense ratios. Some mutual funds add sales loads or 12b-1 fees. ETFs come with a bid-ask spread.
• In taxable accounts, ETFs typically make fewer taxable distributions. In retirement accounts, there's no tax difference.

Check your understanding

You place an order to buy a mutual fund at 10 a.m. on a normal trading day. What price will you pay?

1. The price at 10 a.m., when you placed the order.
2. The NAV calculated after the market closes that day.
3. The previous day's closing NAV.

Sam holds two funds with identical investments, one a mutual fund and one an ETF, both inside a Roth IRA. Which has the tax advantage?

1. The ETF, because it makes fewer capital gains distributions.
2. The mutual fund, because it's priced once a day.
3. Neither. Inside a tax-advantaged account, the difference disappears.

What's next

Many funds, in both forms, simply follow an index. The next lesson, Index Funds, explains how they work and why their costs matter so much.