ETFs vs Mutual Funds: How to Choose What’s Right for You

Last week, we explored the basics of managing investments on your own versus working with a professional. For some, the decision to go it alone is more than a way to save time or money – it’s an exciting opportunity to dive deeper into a topic they genuinely enjoy.

If that resonates with you, one of the first questions you might face is: Should I choose ETFs or mutual funds? These two investment vehicles are cornerstones for building a portfolio, but their distinct characteristics can significantly influence your financial goals and strategy. Let’s break it down.

The Basics: What Are ETFs and Mutual Funds?

Both ETFs (exchange-traded funds) and mutual funds allow you to pool your money with other investors to purchase a diversified portfolio of stocks, bonds, or other assets. Still scratching your head? Think of it this way: Instead of trying to buy a bunch of different stocks on your own – like getting one share of Apple here or a share of Tesla there – you team up with others. By pooling your money, you can buy a larger variety of investments, which helps spread out the risk and gives you more opportunities for growth.

While both ETFs and mutual funds help you invest in a mix of assets, the way they work is different:

• ETFs: Think of ETFs like stocks – you can buy and sell them during the day on a stock exchange, and their price changes throughout the day based on demand. Many ETFs are designed to follow an index, like the S&P 500, so they often don’t need a manager picking investments – there is a growing segment of the market now though called actively managed ETFs.
• Actively Managed ETFs: These funds have professional managers who select investments with the goal of outperforming the market or achieving specific objectives, like reducing risk or focusing on certain sectors. They might be a good fit if you want professional oversight with the flexibility and tax benefits of an ETF, are looking for niche strategies or themes not typically found in index funds and are comfortable with slightly higher fees than passive ETFs. Remember, actively managed funds don’t guarantee better performance, but they can be worth considering for specific goals or interests.
• Mutual Funds: Mutual funds don’t trade during the day. Instead, you buy or sell them through the fund company, and the price is set at the end of the day. These are often run by a professional manager trying to beat the market, but there are also low-maintenance mutual funds that follow an index.

Key Differences: Costs, Flexibility, Tax Efficiency, and Investment Minimums

• Costs – ETFs usually cost less to own because they don’t require as much work from fund managers – most just follow an index like the S&P 500. Mutual funds, especially those with professional managers picking investments, often charge higher fees. Some mutual funds also add extra costs, like sales charges or fees for selling shares early.
• Flexibility – ETFs let you trade anytime during the day, like stocks. If you’re someone who likes having the option to buy or sell quickly, ETFs might be the way to go. Mutual funds only trade once a day after the market closes, so they’re less flexible if you’re trying to time your moves.
• Tax Efficiency – ETFs are known for being more tax-friendly because of how they’re structured—they don’t usually trigger extra taxes when you buy or sell. Mutual funds, on the other hand, might pass along capital gains taxes to you, even if you didn’t sell anything, which could lead to an unwelcome surprise come tax time.
• Investment Minimums – ETFs are often more budget-friendly—if you can afford a single share, you’re in. Mutual funds typically require a bigger upfront investment, with minimums ranging from $500 to a few thousand dollars.

When to Choose One Over the Other

ETFs might be a good fit if you want to keep costs low and are fine with investments that simply track the market (no frills, just results), you like the idea of being able to buy or sell anytime during market hours, and you care about keeping your portfolio as tax-efficient as possible, especially in taxable accounts.

Mutual funds might be a better fit if you want a professional manager actively trying to beat the market and are okay paying a bit more for that chance. They are also a good fit if you’re investing through a retirement account (like a 401(k) or IRA), where taxes on capital gains won’t be an issue until much later. And finally, make sure you don’t mind waiting until the end of the day for trades to settle and can meet the higher minimum investment requirements.

Common Pitfalls to Avoid

Whether you choose ETFs or mutual funds, here are a few traps to watch out for:

• Chasing Performance: Just because a fund did well last year doesn’t mean it will repeat. Focus on long-term potential, not short-term gains.
• Overlooking Fees: Small fees can snowball over time, so always check the expense ratio and any additional charges.
• Ignoring Diversification: Investing too heavily in one sector or fund can leave you vulnerable. Aim for a balanced portfolio.
• Not Understanding the Fund’s Objective: Make sure the fund’s goal matches your own. For example, some funds prioritize growth, while others focus on income or stability.

Getting Started: Practical Steps

1. Define Your Goals and Comfort Zone: What are you saving for – retirement, a home, or something else? Think about how much time you have to invest and how comfortable you are with market ups and downs. You’ll often hear this referred to as your risk tolerance – essentially, how much risk you’re willing and able to handle.
2. Do Your Homework: Use online tools, like fund screeners on sites like Morningstar or your brokerage’s platform, to compare ETFs and mutual funds. Look for things like expense ratios (fees you pay annually to own the fund), past performance, and what’s inside the fund, also known as portfolio composition.
3. Pay Attention to Fees: Even small fees add up over time. For example, let’s say you invest $10,000 for 20 years with an annual return of 7%. With an expense ratio of 0.1%, you’d end up with about $38,000. With an expense ratio of 1%, your final amount would drop to about $31,000. That’s a difference of $7,000 – money that stays in your pocket with a lower fee! This is why keeping an eye on expense ratios matters, especially over the long haul.
4. Think About Taxes: If you’re investing in a taxable account, ETFs can save you money on taxes because of their tax efficiency (a fancy way of saying they don’t make you pay capital gains taxes as often). But if you’re using an IRA or 401(k), taxes are less of a concern, so mutual funds might work just as well.
5. Start Simple and Spread Your Risk: If you’re new to managing investments, keep it simple. Consider a broad-based index fund – whether it’s an ETF or mutual fund – that gives you exposure to lots of different stocks or bonds. This is called diversification, and it’s a key way to reduce risk while learning the ropes.

The Bottom Line
Both ETFs and mutual funds can play a role in your strategy. By learning the lingo and understanding your options, you’ll feel more confident building a portfolio that works for you.