Many investors don't know the difference between mutual funds and ETFs — here's why it matters

  • While traditional mutual funds and exchange-traded funds are similar, considering their differences is worthwhile before choosing which are appropriate for you.
  • Those differences include how they trade, what they cost and the tax implications.

Some investors might want to double-check their familiarity with mutual funds and exchange-traded funds.

A quarter of investors don't have a preference between the two, and 17 percent don't know the difference, according to new research from Raymond James. Forty-four percent favor mutual funds, while 14 percent prefer ETFs.

"It's very important to understand the differences between them," said Frank McAleer, the firm's senior vice president of wealth, retirement and portfolio solutions.

"How you use them depends on your investing time frame, your goals, your financial plan — there are a lot of considerations," McAleer said.

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The data come from a survey that explored broad topics such as satisfaction with progress toward investment goals and investment decision-making. The online poll, conducted in mid-August, surveyed more than 1,000 investors in households with at least $75,000 in investible assets.

While traditional mutual funds and ETFs are similar in many ways, here is a look at their key differences to help you determine how either or both might fit into your investment strategy.

The basics

You probably already know that both traditional mutual funds and ETFs are basically pools of money in which investors buy shares.

Many traditional mutual funds are actively managed, meaning investment experts are at the helm choosing where to invest a fund's assets. Depending on the fund's investment objectives — i.e., growth, income — that generally could be stocks, bonds or cash, or a mixture.

Assets in mutual funds, ETFs

Fund type
Assets (as of 8/31/18)
Actively-managed mutual funds $11.8 trillion
Passively managed index funds $3.6 trillion
Passively managed ETFs $3.6 trillion
Actively managed ETFs $61.9 billion
Source: Morningstar

Other mutual funds are passively managed index funds. That is, they follow an index, such as the Standard & Poor's 500, instead of having someone picking and choosing the investments.

On the ETF side, most are passively managed and follow an index, although a small share do employ an aspect of active management.

Trading

One big difference between traditional mutual funds and ETFs is how they are traded.

Traditional mutual funds — whether actively managed or index funds — can only be bought and sold once daily, after the market's 4 p.m. ET close.

In contrast, ETFs trade throughout the day like stocks. This means investors can react to market news quickly to buy or sell when it suits them.

However, long-term investors — such as those saving for a retirement that's decades away — should generally be sticking to an investment strategy that is not based on trying to time the market.

"Most long-term investors have no real need to be able to transact at, say, 10 in the morning instead of at the end of the day," said Ben Johnson, director of global ETF research at Morningstar, an investment research and management firm in Chicago.

"If anything, that liquidity could be detrimental if it causes them to trade more often than they would otherwise," he said.

Cost

For the most part, actively managed funds cost more than those that are passively managed because you're paying for investment-picking expertise.

In investment funds, the cost is called the expense ratio and is expressed as a percentage. It's the share of your assets that the fund takes each year as compensation for managing your money.

The average expense ratio for actively managed traditional mutual funds is 1.09, according to Morningstar. For index funds, it's 0.79 percent. For ETFs, meanwhile, the passive bulk of them come with an expense ratio of 0.57 percent. The actively managed ones, 0.76 percent.

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Your investment fees matter, because they take a bite out of money that otherwise would be in your account to continue growing. The bigger the yearly expense, the bigger the hit to your earnings over time.

Say you invested $100,000 for 20 years and its annual return was 4 percent. If you paid 0.25 percent yearly, you'd have close to $210,000, according to the Securities and Exchange Commission's Office of Investor Education and Advocacy. By contrast, if you paid 1 percent a year, that $100,000 would grow to only about $180,000.

The investments

As mentioned, actively managed funds have an expert — or team of experts — choosing exactly how to invest your money. The fund's prospectus outlines parameters that the fund managers must follow when choosing investments, and performance is based on whether the fund's management team gets their picks right.

Index funds and most ETFs have no flexibility in the investments, so if the index they track does well, so does your holding. And if the index tanks? Guess what.

New money flowing in (and out) of funds

Fund type
2018 YTD
Actively-managed mutual funds ($44.4 billion)
Passively managed index funds $123.8 billion
Passively managed ETFs $164.3 billion
Actively managed ETFs $17.1 billion
Source: Morningstar

Yet it's been tricky for most actively managed mutual funds to beat their benchmarks and their index-based brethren in recent years, as the bull market that started in early 2009 continues to run. The S&P 500 index is up more than 330 percent from its low of 666 in March 2009.

In theory, in actively managed mutual funds, fund managers can rearrange their mix of holdings to avoid huge losses. While that doesn't always turn out as planned, it's an advantage that could bode well in a bad market environment.

"If this market ever turns — and it will — you'll start seeing articles saying it's time to go to active management," McAleer said. "Active managers can put in place tools that can prevent less pain, so to speak."

Tax treatment

When mutual funds sell investments throughout the year, any profits from those transactions get passed on to the fund's shareholders via capital gains distributions. Those gains can come as a surprise to many investors.

If your mutual funds are in a taxable account, you'll owe taxes on the gains for the year they were distributed. If you hold mutual funds in a tax-advantaged account — i.e., 401(k) plan, individual retirement account — you don't need to worry about it because gains are deferred until you withdraw money in retirement.

"If you're a long-term investor, it's not a big deal," said McAleer. "It's the short-term investor's dilemma."

Generally speaking, capital gains are less likely with ETFs, due to how they are constructed and how they are traded.

Transparency

Most mutual funds disclose their holdings quarterly. In contrast, investors can view a typical ETF's holdings online any time they want.

However, some experts think this difference is overblown as important.

"I'd argue there are very few investors who care to look at all stocks that their ETF owns every day," Johnson said.