There are a number of differences between ETFs and mutual funds, including performance, trading constraints, fund fees, and taxes. Here, we'll break down the details so that you can understand your portfolio.
An exchange-traded fund (ETF) is a security that generally tracks a broad-market stock or bond index, or a basket of assets—just like a mutual fund—but trades like a stock on a listed exchange. By design, index ETFs closely track their benchmarks, such as the S&P 500 or the Dow Jones Industrial Average.
By contrast, most mutual funds are actively managed, and attempt to beat their benchmarks. The performance of the fund can be highly dependent on the portfolio manager making the decision to invest in one stock versus another stock, and can vary from year to year.
ETFs are bought and sold like stocks throughout the day, and are heavily traded amongst many different parties. This liquidity reduces transaction costs, and also makes it easier to trade for on-demand activities like creating or rebalancing a portfolio.
In contrast, mutual funds only trade once a day, and the fund administrator is the only counter-party for buyers and sellers. Mutual funds also have internal trading fees which are not disclosed on top of the stated fee, which are estimated to range from 0.11% of assets to 2%, with an average of 1.44%. So, while many passive index mutual funds’ undisclosed trading fees are likely quite low, they are not zero, which is something to consider when doing a pure cost comparison.
Typically, ETFs have lower expense ratios than mutual funds, despite their typically better net-of-fee performance. This is one of the main reasons—along with better tax efficiency and no minimum balances—that Betterment utilizes exchange traded funds in our portfolio.
ETF managers make money by deducting the annual expenses from the dividends they pay out through the year, and they tell you in advance how much that will be. There are no costs to buy or sell ETFs, and no hidden expenses. If you were to trade through a broker, the broker would usually charge you a commission to execute the transaction. Here at Betterment, we do not charge you any fees outside of our flat advisory fee when we buy and sell ETFs on your behalf.
On the other hand, open-end mutual funds have purchase and redemption fees. These fees range from 0.25% to 2% and are charged by the fund to buy or sell shares within a specified (usually short) period of time. Purchase and redemption fees differ from a commission because the money goes back into the fund rather than to a broker. These fees are meant to discourage short-term market timing.
Some mutual funds have different share classes, each with their own expense ratio and minimum investment.
It’s easy to quickly get deep into the weeds here, but strictly speaking, even a “tax efficient” mutual fund is not necessarily as tax efficient as an ETF.
When you own a share of an ETF, you hold a single security directly for tax purposes, and you’re in control of events that trigger tax consequences. An example of a tax event would be selling the share.
However, when you own a share of a mutual fund, a number of circumstances you have no control over can trigger taxable events for you. The fund manager may choose to sell some underlying securities to rebalance or otherwise readjust the index, or investors other than yourself can withdraw, forcing the manager to sell in a way that can have tax consequences for you, even though you haven’t sold anything. A manager of a “tax efficient” fund presumably seeks to minimize such outcomes, but it may not always be under their control.