Table of Contents
Infographic: ETFs vs Mutual Funds
Quiz: Funds for Investing
Funds let you own a basket of investments in a single buy. See if you can tell an ETF from a mutual fund and active from passive management.
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ETFs vs Mutual Funds: A Complete Beginner’s Guide
ETFs and mutual funds have one difference that could give you very different returns, even when they hold the same investments.
I passed the CFP® exam at 16 and have helped millions improve their finances over the last 8 years. I’ll show you how the two are different and which is right for you.
ETFs vs Mutual Funds: Similarities and Differences
ETFs and mutual funds are both containers that pool your money with other investors’ money to buy stocks, bonds, or other investments.
Mutual funds are often actively managed, which means fund managers choose the specific investments to achieve a certain goal, like getting the highest possible returns.
But surprisingly, over 90% of active fund managers actually underperform the market over the long run.
ETFs – or Exchange Traded Funds – are similar to mutual funds, but are often passively managed. These passive ETFs, which are called index funds, track a stock index, which is a basket of hundreds or even thousands of stocks.
Index funds provide automatic diversification and consistently high returns over the long run – which makes them a great choice for beginners.
Just keep in mind that some ETFs don’t track an index and some mutual funds do track an index.
ETFs trade on an exchange, just like stocks, and their prices change throughout the day. Mutual funds have one price for the whole day. You can buy both from your brokerage account.
The more important difference is fees and taxes.
ETFs vs Mutual Funds: Fees and Expenses
Fees could dramatically reduce your returns. Fees are expressed as an expense ratio, which is the percentage of your investment a fund charges each year.
Let’s look at an example.
Say you invest $150 per month in the stock market for 40 years and the investments earn 11% before fees. At a 0.1% expense ratio, you’ll end up with over $1 million.
But with a 2% expense ratio, you’ll only have around $600,000 – that’s $400,000 less just because of the 2% fee.
It’s possible for ETFs to have high fees and for mutual funds to have low fees, since any fund that’s actively managed will generally have higher fees than a passively managed one.
But as a rule of thumb, ETFs – and especially index funds – have significantly lower fees than mutual funds.
Some mutual funds also have fees for buying or selling, which is called a load. But you can usually buy and sell ETFs without any commissions or fees.
When choosing a fund, make sure to check its expense ratio, and try to pick one that charges less than 0.1% per year and no load.
ETFs vs Mutual Funds: The Tax Difference
While studying for the CFP® exam, I learned that an ETF and mutual fund with the same underlying investments can cost you very different amounts in taxes.
Because of the way mutual funds are structured, you can get hit with capital gains taxes just because other investors sold or because of the fund’s active management, even if you never sold your own shares.
ETFs usually don’t create these surprise tax bills, which leads to higher returns over the long run.
So in a taxable brokerage account, if you’re choosing between an ETF and a mutual fund with the same fees, the ETF is better for taxes.
But if you’re using a tax advantaged account, like a 401k or Roth IRA, then this doesn’t really matter.
Which Is Better for You? A Simple Answer
For most beginners, ETFs – and especially index funds – are better than mutual funds because of the better tax treatment and generally lower fees.
But if a mutual fund has an expense ratio below 0.1% and you’re using a retirement account, that could still be a great investment.
But even people who choose low-cost funds can easily fall for a few common mistakes.
Check this out to avoid 4 beginner investing mistakes that cost investors tens of thousands over the long run, so you can make the most of your investments: 4 Beginner Investing Mistakes That Are Quietly Costing You Thousands