Understanding the Difference Between Mutual Funds and ETF’s

In the world of investing, I can think of very few things that come to mind that could be described as ‘simple’. I could make the argument that the nature of investments and investing is overly complicated and marketed in a way to sway you into thinking that you need to hire a portfolio ‘expert’ if you want to be a successful investor, which I do not believe to be the case. Nevertheless, within this realm there are many types of vehicles where you could choose to invest your money, and two of the more popular options are mutual funds and ETF’s (Exchange-traded funds). I hope this article will help you understand the differences and similarities between the two and be more informed about your investment strategy.

Mutual Funds

Let’s start with mutual funds. There are two types of mutual funds, open-end and closed-end. Since the vast majority of funds are open-ended, this article will focus on these. Mutual funds are simply an investment vehicle which consists of a basket of securities, which can include stocks, bonds, and real estate to name a few. Mutual funds offer investors a way to achieve diversification without needing to invest directly with individual stocks (which you probably need a minimum of $1M to be properly diversified with individual stocks) or individual bonds. An example of a common type of mutual fund would be a target-date fund, which seeks to invest based on a stated ‘target-date’ and adjust the allocation of the fund as it progresses closer to this date. Mutual funds, however, vary in their stated objectives, investment strategies, risk tolerances, etc. and there is no shortage of strategies available. As noted earlier, mutual funds offer investors a way to achieve diversification without the need to invest in individual stocks or bonds. Mutual funds are predominantly ‘actively-managed’ meaning that there is a team who manages the fund and attempts to outperform its stated benchmark by selecting securities based on certain criteria which the team believes will help lead to outperformance. When investing with mutual funds, three of the main factors to evaluate whether or not they make sense for you are their stated objective (which you should be aware of to ensure this objective is in-line with your objectives), the costs associated, and the tax consequences. Let’s look at costs and taxes below.


This management team, as you can imagine, does not work for free. Within each mutual fund there is an expense ratio which relates to the internal costs associated with operations, administration, marketing, and other costs incurred with running this fund, which can sometimes exceed 1% of your investment (ex. You invest $100,000 with a fund with a 1% expense ratio, you are paying $1,000 a year in costs to the mutual fund). Another cost to be aware of are referred to as ‘front-end’ or ‘back-end’ loads. Using the above example of a $100,000 investment, if a mutual fund came with a front-end load of 5.75% (common for A shares), you would pay $5,750 upfront. In exchange for this high upfront cost, you would also most likely receive a lower internal expense ratio, but this may or may not be attractive depending on how long you anticipate holding onto the fund. These are only the stated costs, though, and you should also pay attention to ‘hidden’ costs, such as turnover ratio. Turnover ratio relates to the amount of trading within the fund, either to revert back to a particular allocation or through swapping securities within the portfolio. It is estimated that for every 10% in turnover, you can expect approximately -0.1% in costs. This is due to things like bid/ask spread, commissions, market movements, and other factors. So for a fund with 100% turnover, this would be another 1% in costs an investor would be paying. When you look at the costs involved in investing with actively managed mutual funds, it’s no wonder that the vast majority of active funds underperform their respective benchmarks over time. Next, let’s look at taxes.


Unlike stocks and ETF’s (which we’ll get to next), mutual funds are not traded on secondary markets or exchanges. They are purchased and redeemed by the issuer (the mutual fund company). So when you decide to buy or sell a mutual fund, the fund company actually issues the fund directly to you or purchases the fund back from you (through a broker). Because of this, mutual funds continually need to maintain cash within the portfolio to pay investors who are selling their funds, which not only requires additional holdings turnover (discussed above), but it also can create a headwind for portfolio performance. This constant turnover also leads to capital gain distributions being realized in the fund as positions are bought and sold, which are then passed on to investors at the end of the year. For funds in a taxable account, this can have major tax implications. For example, assume a fund expects a year-end capital gain distribution of 8% (this distribution is usually published in November/December). If you have $100,000 invested in a mutual fund, this is $8,000 of capital gains which are taxed to you at your marginal rate if short-term (as high as 37%) or as long-term capital gains (up to 23.8%)!

Actively managed mutual funds certainly have their place and can be a great option for many investors, but you must know the objective of the fund, as well as the costs and tax implications of the mutual fund before you consider investing your money.

ETFs (Exchange- Traded Funds)

ETFs have gained a lot of popularity over the last decade due to their low cost structure and intra-day trading capabilities. Unlike mutual funds, the overwhelming majority of ETF’s aim to track an index as opposed to trying to outperform the index like an actively managed mutual fund. Tracking an index basically means the composition of the ETF is designed to mimic the composition of an index, like the S&P 500 for example. Because there is not a lot of ‘management’ or administration in running these funds, expense ratios tend to be much lower (Fidelity even offers some 0% expense ratio ETFs!), and we’ll go more into costs next. While many financial planners (myself included) believe you can and should utilize ETFs in your portfolio, there are a number of other factors which we won’t cover in detail here but should be considered when investing in these funds:

  • Which index does the fund use as a benchmark? 
    • There are literally thousands of different types of indexes ETFs can track
  • What is the average daily trading volume of this ETF?
    • Low trading volume indicates it may be difficult to sell during turbulent periods
  • How often does the ETF rebalance and/or trade to re-align with its benchmark?
    • Some ETFs rebalance/trade quarterly, others annually.
  • Which exchange does the fund trade on?
    • New York Stock Exchange, NASDAQ, London Stock Exchange, Tokyo Stock Exchange, etc.

The low cost structure of ETFs is a main proponent of their growth, as costs is one of the factors investors can control when it comes to their investments. As mentioned earlier, ETF expense ratios are typically much lower than mutual funds. Also, ETFs primarily trade on the secondary market, meaning when you purchase or sell an ETF, you are purchasing or selling all of the holdings within that fund ‘in-kind’, so there is not a need to liquidate positions within the fund to raise cash. This helps to keep turnover very low within the fund as well. There are no loads with ETFs, and thanks to the recent dismantling of trading costs across many custodians, most ETFs can be sold without incurring commission costs. So from a pure cost perspective, ETFs are much more appropriate given your investment philosophy.


Unlike mutual funds, ETFs are quite tax efficient. For the reasons described above, low turnover combined with mimicking an index and not selecting specific securities make ETFs extremely tax efficient. There are little to no year-end capital gain distributions like mutual funds either, making them a clear ‘winner’ from a tax perspective.

What about index funds?

Index funds trade like mutual funds (redeemable with the issuer, not traded on secondary markets), but behave like an ETF with their lower turnover, low costs, and index tracking. They are an alternative (and sometimes a better alternative) to similar ETFs and can be a wise investment depending on your investment strategy, but  they do still need to have enough cash on hand to meet redemptions, and can incur year end capital gains just like mutual funds.


Because the objectives and philosophies of actively managed mutual funds and ETFs are not necessarily similar, it is impossible to say whether each makes most sense for your situation. A lot depends on your approach to investing, your time horizon, your objectives, and your opinions about the markets. Both mutual funds and ETFs can be used to construct a diversified portfolio but it is imperative to understand the risks, costs, and characteristics of each.

At FivePoints our belief is the markets are efficiently priced and the best way to achieve long term investing success is by focusing on what we can control by reducing costs, diversifying, maintaining an appropriate level of risk, limiting taxes, and making rational decisions based on logic, not fear or speculation.

Andrew Langdon is a fee-only financial planner based in Peachtree City, GA serving clients in the Greater Atlanta area.  FivePoints Financial Planning provides financial planning and investment management services to young families and pre-retirees who are looking to achieve financial freedom.  Services are offered on a project or ongoing basis.

Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Andrew Langdon, and all rights are reserved. Read the full Disclaimer.