ETFs vs. mutual funds: How they differ

Exchange-traded funds, or ETFs, and mutual funds are both investment products that represent a basket or collection of securities.

"They provide investors access to underlying investments, like stocks or bonds, and generally provide more diversification than a single stock or bond," said Wendy Liebowitz, vice president and branch leader at Fidelity Investments.

However, there are a few key differences between ETFs and mutual funds to keep in mind before investing.

Here’s what you need to know:

ETFs differ in how they are traded

Greg McBride, chief financial analyst at Bankrate.com, explained that mutual funds only trade once per day, after the market close at a price based on the value of all the fund’s assets less the expenses. ETFs, as the name implies, McBride said, trade on an exchange and this means investors can buy or sell throughout the trading day at a price that fluctuates as the prices of the underlying investments change.

"Many fund companies offer both a mutual fund and an ETF version of the same investment, and the ETF is typically the lower-cost option in terms of expense ratio," he said. "Just make sure your brokerage permits you to invest commission-free, as any brokerage commissions erase the modest expense advantage of ETFs."

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ETFs are more passive

Todd Rosenbluth, head of research at VettaFi, explained that similar to mutual funds, ETFs provide investors with the benefits of diversification, by owning stocks or bonds from numerous companies.

"However, most ETFs outperform mutual funds in the same investment style as they cost less and passively track an index like the S&P 500 or the Russell 2000 Index rather than try to pick winners but end up with laggards," Rosenbluth said. "Most ETFs available track an index and are passively managed, while most mutual funds are actively managed with the team picking through a larger universe of investments."

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ETFs generally cost less

The fees you pay to purchase ETFs tend to be lower than mutual funds, but this does vary depending on the investments. A significant reason it’s cheaper is that an ETF is a passive fund.

"ETFs tend to have a lower cost of ownership, with expense ratios often less than 0.20%, while mutual funds are often five times as expensive," said Rosenbluth.

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ETFs can offer tax advantages

Another difference to consider is tax efficiency.

"Generally, holding an ETF in a taxable account will generate less tax liabilities than if you held a similarly structured mutual fund in the same account," said Liebowitz with Fidelity Investments. Although both are subject to capital gains and dividend income tax, Liebowitz said ETFs generally have fewer taxable events than mutual funds.

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Understand the ramifications of investing

Liebowitz stated it is important to review the portfolio fundamentals of any fund before investing.

"While an ETF and mutual fund might have the same investment objective or investment ‘style,’ the composition of each fund could vary, so investors should compare the annual turnover ratio, concentration risk, expense ratio, and other risk factors to determine if it is right for them and what they are trying to achieve with their investment," she said.

Despite their differences, Liebowitz explained that both mutual funds and ETFs can offer investors exposure to a diversified basket of securities to help meet their financial goals and objectives – and it doesn’t have to be one or the other.

"Investors should pick the best choice for their specific investing needs, keeping their time horizon, risk tolerance, financial circumstance, and short- and long-term goals in mind before making any investment decision," added Liebowitz.