Exchange-traded funds (ETFs) and mutual funds are popular investment vehicles. They can be used by investors who don’t want to go down the route of individual stock picking. Both have a fund manager, often backed by a team of investment professionals who take on all responsibility for making investment decisions aligned with a specific investing strategy.

Investing through a fund effectively enables retail investors to put their portfolios on autopilot. This is known as passive investing. ETFs and mutual funds share a lot of characteristics. But they also have stark differences in they are structured and traded.

So, in the battle between an ETF vs a mutual fund, which is the better investment?

What is an ETF?

An exchange-traded fund pools shareholder capital into a single pot. It then reinvests this money into a basket of financial securities. There are seven different types of ETFs which operate using various investing styles and strategies. And each has its own set of advantages and drawbacks for investors to consider.

• Index ETF – Tracks and replicates the performance of a stock market index such as the FTSE 100. This is a type of index fund.
• Industry ETF – Tracks and replicates the performance of an industry or subsector.
• Bond ETF – Invests in a broad range of debt instruments, including government bonds, corporate bonds, and municipal bonds.
• Commodity ETF – Tracks and replicates the performance of an individual or basket of commodities such as lumber, oil, or gold.
• Currency ETF – Tracks and replicates the performance of specific foreign and domestic foreign currency pairs.
• Inverse ETF – Tracks and replicates the opposite performance of financial assets such as stocks or bonds.
• Leveraged ETF – Tracks the performance of an index, sector, bonds, commodity, or currency using leverage to maximise returns at the cost of taking on additional risk.

An ETF is traded on a stock exchange like the London Stock Exchange or New York Stock Exchange. This makes them highly liquid assets that can be bought and sold, just like individual stocks.

Typically, ETFs designed to track the performance of an index, sector, or commodity are passively managed. As such, the expense ratio of these funds tends to be very low. On the other hand, a fund seeking to outperform a particular benchmark is often actively managed. An actively managed ETF typically has higher annual management fees to cover the costs of financial research and analysis.

What is a mutual fund?

A traditional mutual fund operates almost identically to an ETF. It pools money from multiple investors to invest in a portfolio of financial securities. These securities can range across various asset classes, including stocks, bonds, commodities, real estate, and derivatives. Depending on which asset classes and investment strategies are being executed, a mutual fund can be categorised into five different fund types.

• Stock Fund – Invests exclusively in equities to match or outperform a stock market index like the S&P 500. When the fund attempts to replicate the performance of an index, it is classified as an index mutual fund.
• Bond Fund – Invests exclusively in debt securities such as government bonds, corporate bonds, municipal bonds, convertible bonds, and mortgage-backed securities, among others.
• Balanced Fund – Invests using both stocks and bonds to execute a specific investment strategy.
• Money Market Fund – Invests exclusively in short-lived debt securities such as treasury bills, commercial papers, and certificates of deposits.
• Target Date Fund – Invests in a wide range of asset classes, adjusting the strategy to become more conservative as the investor gets older.

Passive mutual funds seek to track the performance of a benchmark index or sector. And there are also active mutual funds aiming to outperform these benchmarks, which come with a higher expense ratio.

However, these funds are not traded on an exchange. And therefore, shares can only be purchased and sold to the fund itself. A mutual fund’s share price is determined by the Net Asset Value (NAV) – the value of its investment portfolio. Trades to buy and sell shares in a mutual fund are settled at the end of each trading day, which is also when the NAV updates as well.

ETF vs mutual funds: The similarities

• Asset Exposure – Both ETFs and mutual funds can invest in multiple asset classes, including those that retail investors may not typically have access to.
• Instant Diversification – Both mutual funds and ETFs invest shareholder capital across a diversified collection of securities. As such, fund investors can create a diversified portfolio within a single transaction.
• Active & Passive Strategies – ETFs and mutual fund managers are free to deploy an active or passive investment strategy to either replicate the performance of a benchmark or try to beat it.
• Dividends – Both ETFs and mutual funds pay dividends based on the dividends and coupons received from stocks and bonds held within the fund’s portfolio.

ETF vs mutual funds: The differences

• Trade Executions – As ETFs are traded on an exchange, buying or selling shares occurs almost instantly while the stock market is open. However, mutual fund shares are not traded on an exchange. Instead, they are directly bought from and sold to the fund itself, which occurs only once per day at the end of the trading session.
• Investment Requirements – A mutual fund can sometimes have a minimum investment requirement. This can raise the barrier to entry for lower net-worth investors with smaller amounts of capital at their disposal. By comparison, an ETF doesn’t have minimum investment requirements. Investors simply need to be able to afford at least one share at the current stock price. Having said that, some brokers have begun offering fractional shares for certain ETFs, further reducing the barrier to entry.
• Fees – A mutual fund can sometimes be more expensive if entry and exit fees are charged. This is especially true for an actively managed mutual fund. These fees are set to cover the higher administrative and operating expenses of running an ETF vs a mutual fund. That’s why the latter does not charge entry or exit fees, making it often the cheaper option of the two in terms of expense ratios.
• Volatility – Both mutual funds and ETFs are typically highly liquid instruments. However, because ETFs can be actively traded throughout the trading day as opposed to just once per day, they have a reputation for being more volatile.

The bottom line

ETFs and mutual funds are very similar investment vehicles that cater to different investor objectives and risk tolerances. The ability to buy and sell shares similar to a stock makes ETFs more suitable for more active investors, but they are also more susceptible to higher inter-day levels of volatility.

All things considered, the victor of the battle between ETF vs mutual fund ultimately depends on the circumstances and desires of an individual. Investors should thoroughly research the advantages and disadvantages of both types of funds to determine which is most suitable for their investment portfolio. And if uncertainty remains, it’s often prudent to speak to a qualified independent financial adviser.

This article contains general educational information only. It does not take into account the personal financial situation of the reader. Tax treatment is dependent on individual circumstances that may change in the future, and this article does not constitute any form of tax advice. Before committing to any investment decision, an investor must consider their individual financial circumstances and reach out to an independent financial advisor if necessary.