Putting money into funds is one of the most common ways for people to grow their wealth over time. Many investors use either Exchange-Traded Funds (ETFs) or mutual funds to get broad market exposure when they want to save for retirement, make a big purchase, or just build a diverse portfolio. It’s important to know how these two types of investments work so you can make smart choices as index-based investing becomes more popular.
This article will explain what ETFs and mutual funds are, and then it will give you five big reasons why ETFs are better than mutual funds. In the end, we will help you figure out which type of fund might be best for your long-term financial goals by breaking down each benefit with clear, detailed comparisons, real-life examples, and useful advice. These tips will help you get the information you need to do well, whether you’re new to investing or want to make your portfolio strategy better.
You can put money into a group of stocks, bonds, or other assets with both ETFs and mutual funds. For a long time, people have called mutual funds a “set it and forget it” choice. Professionals usually run them and make choices based on how the market is doing from time to time. ETFs, on the other hand, have become very popular because they have low fees and combine the ease of mutual funds with the freedom of stock trading. This unique combination makes ETFs a good choice for investors who want to act quickly.
In the next sections, we will first define and explain these common types of investments. Then we will talk about the specific benefits that ETFs have over traditional mutual funds. Lower costs, great liquidity, impressive tax efficiency, and daily transparency are all important parts of building a strong and flexible investment portfolio. Let’s first figure out what ETFs and mutual funds are.
1. What are mutual funds and ETFs?
It’s important to know what ETFs are and how they are different from and similar to mutual funds before you look at their benefits.
What are mutual funds and ETFs?
- ETFs, which stands for “Exchange-Traded Funds,” ETFs are investment funds that hold different types of assets, such as stocks, bonds, or commodities, and are meant to track the performance of a specific index. Unlike other funds, ETFs trade on stock exchanges all day, just like individual stocks. This means that prices of ETFs change during market hours, so investors can buy or sell shares at prices that are current.
- Funds that work together: Mutual funds also pool the money of many investors to buy a lot of different types of securities. But mutual funds are usually run by professional portfolio managers, and their prices are only set once a day, at the end of the day when the net asset value (NAV) is set. Because of this one-time daily pricing, you can’t trade during market hours. All buying and selling transactions are done at the same closing price.
How They Work
- How the market works: When the market is open, investors can buy and sell ETFs. This lets them react to news and changes in the market in real time. You can only buy or sell mutual funds directly from the fund company at the end of the trading day, though. This means that investors have less control over when they can trade.
- Costs and Fees: One of the main differences is how they are billed. Most ETFs have lower expense ratios because they are passively managed. Management fees for mutual funds, especially those that are actively managed, are usually higher. They might also charge sales loads, which are fees you have to pay when you buy or sell.
- Minimum investments: Most mutual funds require a minimum initial investment, which can be anywhere from a few hundred to several thousand dollars. You can buy ETFs by the share at the market price, which means you don’t need as much money to start.
What are the main differences and similarities?
ETFs and mutual funds both help investors spread out their investments by letting them buy a lot of different stocks at once. Buying shares of an ETF that tracks the S&P 500, for instance, gives you access to 500 of the biggest companies in the US. Mutual funds may give you similar exposure to the overall market, but they usually do so with active management that tries to beat the market. This strategy has its own set of problems and costs more.
Differences to Keep in Mind:
- How often do you trade?
- ETFs: You can trade them all day long, which lets you see prices during the day and use trading strategies like limit orders and stop-loss orders.
- Mutual Funds: You can only trade once a day, at the end of the day.
- Ratios of Costs:
- ETFs: Usually lower because they are managed passively.
- Mutual Funds: These are usually higher, especially the ones that are actively managed.
- Being open:
- ETFs: Show what they own every day.
- Mutual Funds: They usually tell you what they own every three months.
These differences help you understand what makes ETFs so unique. In the next few sections, we’ll look closely at five main reasons why ETFs are such a good investment choice.
2. Advantage #1: Lower fees and expense ratios
Many investors are choosing ETFs over mutual funds because they are cheaper. This is because ETFs charge lower fees and have lower expense ratios. Because of the power of compounding, even a small change in fees can have a big impact on your total returns over time.
Getting to Know Ratios of Expenses
- What is an expense ratio? The expense ratio is the amount of money that is taken out of an asset’s value each year to pay for things like management fees, fund operating costs, and other costs. For example, if you put in $1,000 into an ETF with an expense ratio of 0.20%, it will take $2 off of your investment every year.
- Effect Over Time: A small difference in fees between an ETF and a mutual fund can make a big difference in the value of your investment after a few years. If you put $10,000 into a fund that charges 1% a year and an ETF that charges 0.20%, the ETF with the lower fee can end up making a lot more money over 30 years at a 7% annual return than the mutual fund with the higher fee.
The Fees and Structures of ETFs
- Lower Costs and Hands-Off Management: Most ETFs are passively managed, which means they are meant to track how well a certain index does. ETFs usually have lower management fees because you don’t have to make decisions and change your portfolio often.
- Less Expensive to Run: Because ETFs trade on an exchange, they tend to have lower overhead costs than actively managed mutual funds, which have higher costs because they are always trading and making management decisions.
Mutual Funds and Higher Costs
- Extra cost for active management: A lot of mutual funds, especially those that are actively managed, have teams of analysts and portfolio managers who are always trying to do better than the market. Active management usually means higher salaries, research costs, and trading costs. These costs are then passed on to investors in the form of higher expense ratios.
- Sales Loads and Other Costs: Some mutual funds have higher annual expense ratios and higher transaction fees, as well as front-end or back-end loads (sales commissions). These extra costs can cut into your overall returns, especially when you first invest or when you change the balance of your portfolio.
A real-life example of how to save money
Let’s consider an investor who compares two funds:
| Investment | Expense Ratio | Initial Investment | Annual Fee (for $10,000) |
|---|---|---|---|
| ETF | 0.20% | $10,000 | $20 |
| Mutual Fund | 1.00% | $10,000 | $100 |
At first, the difference in fees may not seem like a big deal, but over 30 years, the ETF’s lower fees can add up to much higher returns. Fees take less money out of the market, so every dollar stays in the market to benefit from growth.
The Effect of Compounding
- Effects Over Time: Think about compound interest: if you reinvest the money you save by paying lower fees, you can make more money over time, which will help your portfolio grow even more. As shown above, the money saved by paying $80 less per year goes back into the business and starts to make money on its own. This small difference adds up over time, making ETFs much cheaper in the long run.
- Better Performance of the Portfolio: More capital stays invested because of lower recurring fees, which leads to stronger growth. Long-term investors, especially those who invest in taxable accounts, need to lower their fees. This is because lower costs mean higher net returns.
Why Long-Term Investors Should Care About Fees
- Affecting returns that build up over time: The math behind ETFs is easy: fees are less than returns, which is one of the best things about them. As your wealth grows over time, even a small drop in the expense ratio of your fund can have a big effect on the results.
- Lessening the effect on performance: In markets that do well, a fund with a higher expense ratio can still do worse than a fund that is the same in every way but costs more. Over time, fees can “drag” down your overall investment gains.
What the Investor Should Know
ETFs are a great choice if you want to grow your money over time and keep costs low because they usually have lower expense ratios. ETFs let you keep more of what you make because they charge lower fees. This makes a big difference as your investment grows year after year.
3. Benefit #2: Trading is more flexible and liquid.
Another big benefit is that ETFs are much more flexible and liquid than mutual funds. This benefit gives investors more freedom to manage their investments and respond to changes in the market right away.
Prices and trading during the day in real time
- How ETFs Work: You can buy and sell ETFs on stock exchanges, just like you can with stocks. You can see how the price of your shares changes throughout the day instead of having to wait until the end of the trading day to find out how much they are worth. This lets you make smart decisions based on what’s going on in the market right now.
- Advantages of Real-Time Pricing:
- Active Management Strategies: Investors who want to quickly change their portfolios in response to market events can buy or sell ETFs during trading hours.
- Limit and Stop Orders: You can set limit orders to control the price at which you buy or sell, which is not possible with mutual funds because they only set their prices once a day.
- Flexibility to React: When the market is very volatile, being able to trade during the day lets you manage risk better by quickly locking in gains or limiting losses.
Advantages of Liquidity
- A lot of trading: A lot of ETFs, especially those that follow major indices like the S&P 500, have a lot of trading volume every day. This liquidity means that there is always a market where you can buy or sell shares without having a big effect on the price.
- Small Spreads: There are a lot of market makers and traders for ETFs, so the bid-ask spreads are usually small. This helps you avoid losing money on a bad deal when you buy or sell.
Comparing with Mutual Funds
- Windows for trading: Mutual funds, on the other hand, are only priced once at the end of each trading day, when the market closes. This means that the price will always be the same at the end of the day, no matter what time you place your order. This restriction can be a problem if the market moves a lot during trading hours.
- Order Types That Aren’t Flexible: You can’t place limit orders or stop-loss orders with most mutual funds. ETFs are better for investors who want to have a lot of control over the prices at which they buy and sell.
Examples and Situations in Real Life
Think about being an investor who watches the market closely and wants to buy more stocks when prices go down for a short time. With ETFs, you can do the following:
- Do things in real time: You see the ETF you want to buy drop by 2% in the middle of the day. You can buy shares right away with a limit order at a set price, instead of waiting until the end of the trading day, when the price might have gone back up.
- Take care of rebalancing your portfolio: If the market suddenly changes the way your portfolio is set up, ETFs let you quickly rebalance your positions throughout the day. This is how you can keep your risk level where you want it to be.
Better control over your portfolio
- Risk Management That Changes ETFs let you quickly get out of positions if the market goes against you or take advantage of short-term trading opportunities without changing your long-term strategy.
- Making it easier to make tactical changes: Even long-term investors can move parts of their portfolios around when they see good short-term deals during the day. This is because they don’t have to stick to a once-a-day pricing schedule.
Last Thoughts on Being Able to Trade
ETFs are better than mutual funds because investors can trade them all day and they have better liquidity. This is important for investors who want to grow their money over time and be able to change their portfolios quickly. This flexibility can help your portfolio do better in the long run because you have more control over how and when you change your positions in response to changes in the market.
4. Third benefit: tax efficiency
When it comes to making the most of your investments over time, tax issues are very important. ETFs are usually better at this than mutual funds. This is mostly because of their unique structure and the way they create and redeem money “in-kind.”
Learning About the Effects of Taxes
- Capital Gains in Mutual Funds: When mutual funds sell securities in their portfolio—whether to meet redemptions or as part of active management—they may realize capital gains. Then, all of the shareholders get these profits, and they have to pay taxes on them even if they haven’t sold any shares.
- The One Thing That Makes ETFs Special: ETFs usually don’t give out as many capital gains that you have to pay taxes on. This is because of the in-kind redemption process, in which large institutional investors “exchange” ETF shares for the assets that make up the fund instead of the fund selling securities to get cash. Because of this, ETFs lower the amount of capital gains that are realized, which makes growth more tax-efficient.
The System for Creating and Redeeming in Kind
- How It Works: When an investor wants to sell a lot of ETF shares, ETF providers can give the underlying securities to an authorized participant in exchange for ETF shares instead of selling them and possibly making capital gains. This “in-kind” transfer means that no sale takes place, so there are no capital gains.
- An advantage in comparison: Mutual funds are more likely to give their investors capital gains because they often have to sell securities to meet redemption requests or rebalance their portfolios. These distributions can add up to a big tax bill over time, which will lower your overall returns.
Quantitative Examples and Ways to Save
Imagine two investment vehicles—one mutual fund and one ETF—each generating an annual return of 7%. The mutual fund’s higher capital gains distributions could be a big tax burden for a long time, especially in taxable accounts.
- A list of examples:
| Element | ETF | Fund of Funds |
|---|---|---|
| Yearly Return (Before Taxes) | 7% | 7% |
| Average Tax on Capital Gains | Not High | More |
| Efficient with taxes | Very high | Less |
Over several decades, this differential in tax efficiency can mean that ETF investors retain a larger portion of their gains, leading to higher compounded returns.
Taxable Accounts Are Good
- Lowered Tax Bill: If you have ETFs in taxable accounts, you can save a lot of money on taxes by getting fewer taxable distributions. When you pay less in taxes each year, you have more money to reinvest, which makes your returns grow even faster.
- Building Wealth Over Time: Taxes are one of the few costs of investing that you can’t avoid, so it’s important to keep track of them over time. ETFs usually have a better tax situation, which is good for long-term investors who want to get the most out of their money.
Things Investors Should Think About
- Tax-Loss Harvesting: ETFs are also good for tax-loss harvesting strategies because they are easy to buy and sell and are clear. You could, for instance, sell an ETF at a loss to make up for gains in other parts of your portfolio. Then, you could buy back a similar asset. This would keep your long-term plan in place and lower the tax impact.
- Ways to reinvest: When distributions are taxed less, dividend reinvestment strategies work better. Putting the money saved on capital gains tax back into the business will make long-term returns even higher.
Conclusion on Tax Efficiency
One of the most important things for long-term investing to work is tax efficiency. ETFs have built-in ways to reduce taxable events, so investors in taxable accounts can get lower capital gains distributions, which means they keep more of their investment earnings. ETFs have better overall net performance than many mutual funds because they have lower tax liabilities that lower your returns over time.
5. Advantage #4: It’s easy to see what you own
More and more investors, both new and experienced, are interested in transparency. ETFs give you a lot of information about what you own, which can help you make smart investment choices.
Daily Disclosure of Holdings
- Daily Updates on ETFs: One great thing about ETFs is that they have to tell people every day what they own. This means that investors can almost see the assets that make up their ETF in real time. This level of openness lets you see exactly which stocks or bonds are included, keep an eye on sector exposures, and figure out how much risk you’re taking at any given time.
- Good for Investor Confidence: Daily reports give investors the information they need to understand how market events could affect their portfolios. If a major geopolitical event happens, for example, you can quickly look at your ETF’s holdings to see how much exposure it has to the affected industries or regions.
Look at Mutual Funds
- Reporting less often: Most mutual funds only tell investors what they own once every three months. This delay in information can sometimes make it hard for investors to know about recent changes or strategies by the fund manager, which makes it harder to quickly figure out the real risk and performance.
- Effect on Making Decisions: When a mutual fund reports its holdings every three months, it can be hard for investors to tell if the fund’s changing makeup is in line with their risk tolerance or long-term strategy. On the other hand, ETF investors can make better decisions based on the most up-to-date information about how their assets are spread out.
Why it’s important to be open
- Managing Risk: Knowing what you own helps you take better risks. You can quickly see if a certain asset class or sector is too big in your portfolio and make changes to it if you have more transparency.
- More Trust and Confidence: When you see the product every day instead of just when the fund manager sends you reports, you can trust it more. You can easily change your plans if you need to because you can always see what’s going on. This way, there won’t be any surprises when the market changes.
- For example: Let’s say you invest in an ETF that tracks a broad market index. You can tell from the daily holdings report that a lot of assets have moved into a sector that is known to be unstable. Knowing about this change can make you rethink your exposure or spread it out more to protect your long-term strategy.
Advantages of Technology
- Simple to Get to: It’s usually only a few clicks away to find out about ETF holdings on today’s brokerage platforms and financial news sites. With this level of access, you can keep an eye on things without having to pay for special tools or subscriptions.
- Portfolio changes that are based on facts: It’s important to be honest about what you have, but it’s also a way to improve. When you know exactly what your portfolio is made up of, you can make better decisions about rebalancing, tax-loss harvesting, or changing your investments based on what the market is doing.
What Investors Should Know
ETFs are a lot better than mutual funds for people who want to be able to see what’s going on and have control over their money. This level of openness not only makes your investments clearer, but it also gives you the information you need to keep improving your portfolio. When it comes to managing risk and getting the most out of your investments, knowledge is power.
6. Advantage #5: Easy to get to and low minimum investments
Last but not least, ETFs are easy to buy and don’t require a lot of money to start, which is another big plus. This is a big reason why new and small investors who want to build a diverse portfolio without spending a lot of money are interested in ETFs.
Easier to get in
- No Minimum Investment Required: One of the best things about ETFs is that you can buy just one share. You don’t have to put in a certain amount of money, which is different from a lot of mutual funds that ask you to put in at least $1,000 to $3,000 or more.
- Small investors can be flexible: ETFs are a good choice for young investors, people who are just starting to save money, or anyone who wants to invest a smaller amount of their extra money because they are easy to get into. Anyone can start investing with the cost of one share, so it’s open to everyone.
Cheap and varied
- Making a portfolio with a lot of different types of investments: Many people find the idea of diversifying their portfolios scary because it costs so much. You don’t have to open accounts that require a lot of money because ETFs let you buy hundreds of securities with just one purchase.
- Shares that aren’t full Many modern brokerages now let you buy fractional ETF shares, which makes it even easier to invest because you can put in exactly the amount you want—down to the dollar—and still get a mix of sectors and asset classes.
Real Benefits for New Investors
- Simple to Dollar-Cost Average: There is no minimum investment amount for ETFs, so they are great for dollar-cost averaging. That means you put the same amount of money in every time, no matter how much the stock price is. This can help you develop good investing habits and lessen the effects of market fluctuations over time.
- No Commitment to High Initial Sums: ETFs let you start small, build your portfolio over time, and easily reinvest dividends. This is different from mutual funds, which may require a large initial investment. This flexibility makes it less risky for new investors because it lets them slowly add to their investments as they become more sure of their choices.
Available on all platforms
- Can be found in a lot of places: You can buy ETFs on almost any brokerage platform and they are listed on all the major stock exchanges, so they are easy to find. You can buy and sell ETFs just like stocks, whether you use a traditional brokerage or a modern investment app.
- Tools for Learning: A lot of brokerages now have a lot of educational materials about ETFs, such as tutorials, webinars, and research reports. People who are new to investing can really benefit from being able to get real-time information and expert advice. It can help them along the way.
What Investors Should Know
ETFs are a game-changer for many investors because they are easy to get into and have low entry requirements. ETFs let almost anyone invest in the financial markets, even if they don’t have a lot of money to start with. They do this by lowering the cost of entry and making it easier to get a wide range of market exposures. This feature is especially useful for new investors who want to try out different strategies and build up their returns without putting too much money at risk right away.
7. Extra Section: When Mutual Funds Might Still Be a Good Idea
Even though ETFs have a lot of benefits over mutual funds, there are times when mutual funds are better. Depending on your needs, investment style, and overall strategy, mutual funds might be the best choice for you at times.
Advantages of Mutual Funds
- Management in Action: Many mutual funds are actively managed, which means that professional portfolio managers pick stocks and bonds in an effort to beat the market. If you don’t want to think about how the market changes every day or don’t believe in the value of professional knowledge, actively managed mutual funds might be a better option for you.
- Plans for Investments That Happen Automatically: Most mutual funds have strong automatic investment plans that make it easy to add money on a regular basis without having to trade each time. People who like to invest passively or who are saving for long-term goals like retirement will like this “set it and forget it” method.
- Stable Capital Deployment: In some cases, the way mutual funds are set up can make the investment environment more stable, especially for investors who want to be able to easily access their money and get clear daily valuations at the closing price.
When to Consider Mutual Funds
- Plan for Your Own Investment: If you want to actively manage your investments, mutual funds might be a better fit for your goals. Investors who want personalized management that always tries to beat the market may prefer mutual funds, even though they cost more.
- Long-Term Investments in Retirement Accounts: Mutual funds can be a simple way to invest regularly in retirement accounts that don’t have to worry about taxes as much. The fact that they are easy to use and professionally managed can make them appealing for retirement portfolios that don’t have to pay capital gains taxes every year.
Finding a Balance
In the end, the choice between ETFs and mutual funds comes down to your preferences, your financial goals, and how much you want to keep an eye on your portfolio. There is a place for both kinds of investments, and a lot of investors may even choose to have both to get the best of both worlds.
8. Last Thoughts
When investors look at the two side by side, the benefits of ETFs over mutual funds can be very convincing. Let’s go over the five main benefits:
- Fees and expense ratios that are lower: ETFs usually have lower management fees, which means you get to keep more of the money you make from your investments. This is especially important for investments that will last a long time.
- More ways to trade and more liquidity: ETFs trade all day on major exchanges, giving investors real-time prices, the option to place limit orders, and more flexibility for rebalancing and managing risk.
- Tax Efficiency: ETFs tend to have fewer taxable events because they create and redeem shares in kind. This means that taxable accounts will have fewer capital gains distributions and higher net returns.
- Clear view of Holdings: ETFs tell you what they own every day, which gives you more information about your investments and lets you make better decisions. Mutual funds, on the other hand, only tell you what they own every so often.
- Easier to get to and lower minimum investments: ETFs let investors get into the market with little money because you can buy just one share without having to put down a lot of money up front. This is a big plus for building a diversified portfolio from scratch.
ETFs have these great benefits, but each investor should think about their own goals, how much risk they are willing to take, and how they like to invest. In some cases, like when you want to actively manage your money or have automatic investment options, mutual funds might still be a good choice.
If you know the differences between these two vehicles, you can make better choices that will help you reach your long-term financial goals. You can make better investment decisions if you know why you want to use ETFs. For example, you might choose them because they have low fees, are easy to trade, are tax-efficient, are clear, and are easy to get to. You could also mix them with mutual funds to make a balanced approach.
9. Questions that are often asked
Below are some frequently asked questions to help clarify common concerns about ETFs compared to mutual funds:
Q1. Is it easy for me to switch from mutual funds to exchange-traded funds (ETFs)? Answer: Yes, many brokerage platforms let investors switch between mutual funds and ETFs without charging too much. But you should think about things like taxable events and when the switch will happen. If you have money in taxable accounts, it might be a good idea to talk to a financial advisor about how to make the move go smoothly.
Q2. Are ETFs riskier than mutual funds? Answer: Not by nature. The risk of either investment is more about the assets that are backing it up than the structure of the fund itself. ETFs usually follow broad-market indexes or specific sectors, so their risk levels can be similar to those of mutual funds. Some ETFs, like leveraged or niche ETFs, can be riskier because they use special strategies. To understand the risk profile, always read the prospectus.
Q3. What are the differences between how taxes work for ETFs and mutual funds? Answer: ETFs are usually better for taxes because they create and redeem shares in kind, which lowers capital gains distributions. When you change your portfolio, mutual funds, especially those with active management, often make more capital gains, which means higher taxable distributions. This difference can make mutual funds pay a lot more in taxes over time in taxable accounts.
Q4. Do ETFs give out dividends? Answer: Yes, a lot of ETFs pay dividends if the companies in the fund do. Your broker will tell you whether you can take these dividends as cash or automatically reinvest them. The dividend yield may change depending on the ETF’s investments and what it focuses on.
Q5. What are the best ETFs for beginners? Answer: People who are new to investing are often told to buy ETFs that track broad-market indexes, like those that mimic the S&P 500 or total market indexes. These ETFs are good because they lower your risk and aren’t too risky. Funds like the Vanguard S&P 500 ETF or other similar ones can be a good starting point until you’re ready to look into more specialized or actively managed ETFs.
Q6. How much do expense ratios matter for my long-term returns? Answer: Very important. Even small differences in expense ratios can compound over time, significantly impacting the overall growth of your investment. ETFs with lower fees usually let you keep more of your money invested and growing, which means you get more money back over time.
Q7. Can I have both ETFs and mutual funds in my portfolio? Answer: Yes, of course. Many investors choose a blend of ETFs and mutual funds to take advantage of the benefits of both. For example, you could have a low-cost ETF that gives you a broad view of the market and a mutual fund that lets you manage your investments yourself or automatically. The most important thing is to make sure that your investments are in line with your risk tolerance and long-term financial goals.
Last Thoughts
People who want to get the most out of their investments need to know the good and bad things about ETFs and mutual funds. Investors looking for long-term growth like ETFs because they have lower fees, more flexibility during the day, better tax efficiency, daily transparency, and easy entry points. But the best investment for you will depend on your goals, how much risk you’re willing to take, and how you like to invest.
You can make choices that will help you make more money over time by learning about these important benefits. Keep in mind that ETFs have some great benefits, but a balanced approach that includes both ETFs and mutual funds can help you build a strong, diverse, and well-rounded portfolio.
Have fun with your investments, and I hope the choices you make today will help you grow a lot in the future!