Mutual Funds vs. ETFs vs. Index Funds

By Justin Pritchard, CFP®

It’s important to know where your money goes. As you research investments, you might hear suggestions to use mutual funds, ETFs, and index funds for low-cost investing.

People often use those terms interchangeably, which could make you wonder what you’re using and if you’re using the right tools to invest for your future.

So, let’s compare and contrast the features of ETFs vs. mutual funds vs. index funds for the average investor. That might be somebody with roughly several hundred thousand dollars (or less) invested. And for most people, the majority of that is in retirement accounts like IRAs or a 401(k) plan.

Key takeaways:

  • ETFs and mutual funds share similar features, including easy diversification.
  • The differences between ETFs and mutual funds might not matter for many investors.
  • The mechanics of trading differ depending on whether you use mutual funds vs ETFs.
  • ETFs might enjoy some tax efficiencies outside of retirement accounts.
  • Index funds employ a passive approach, typically resulting in lower costs and performance that follows the markets.
  • Both mutual funds and ETFs are available as index (or passive) funds.

For now, we’re focusing on long-term investors who want to use boring, textbook approaches to investing. This is not geared toward those who invest for entertainment or as a hobby. We’ll include funds that might make up the core of a portfolio, but we won’t get into the most esoteric holdings that many investors never touch (and might not need to).

At a high level, we’ll focus on:

  • Benefits of using these investment options
  • Similarities and differences
  • How you prefer to invest
  • Tax considerations
  • Costs
  • Active vs. passive investing

After reviewing those topics, you should have more clarity on which option is best for you.
Continue reading below, or get similar information from this video.

Key Similarities: Mutual Funds and ETFs

ETFs and mutual funds are very similar. Technically, they even share the same underlying structure as open-end investment companies as defined by the SEC. These investments provide a way to easily invest in numerous different investments with a single fund.

For many investors, there might not be much difference between using ETFs vs. mutual funds. As a result, it might not really matter which one you choose. That said, there are some important differences that might be relevant for you, and you might be an exception.

What Is a “Fund?”

Mutual funds and ETFs are both pools of money that can buy a variety of investments. For many people, a fund is an easy way to get exposure to stocks and bonds.

Funds typically have an objective, such as investing in the U.S. stock market. So, the fund’s holdings should match that objective. For example, a U.S. stock fund would typically buy stocks of companies based in the U.S.

The most important thing to remember might be that a “fund” is a pool of money that numerous investors can use.

Diversify Easily

Mutual funds and ETFs both offer easy diversification. In this area, they are roughly equal.

Diversification might be the primary benefit of using mutual funds and ETFs. By spreading your assets among various investments, you improve the chances of being in the right place at the right time, and you reduce the chances of having heavy exposure to the wrong places at the wrong time.

That said, diversification doesn’t eliminate the risk of loss completely, and it’s theoretically possible that you’d do better if you successfully pick the right stocks (but that’s risky, and not something I’d bet on).

For example, say you want to invest in large U.S. companies. With either a mutual fund or an ETF, you can buy a single fund with exposure to those types of investments.

That’s significantly easier than trying to diversify on your own.

For example, if you wanted exposure to roughly 500 large companies in the U.S., you’d have to place 500 individual purchase orders (after first identifying the 500 companies you want to invest in). That takes a significant amount of effort.

Purchasing a single fund can provide access to hundreds (or more) of investments.

Various Objectives

You can probably find funds that invest in most of the areas you want exposure to. For instance, you can find both mutual funds and ETFs that invest your money in the following:

  • U.S. stocks
  • Overseas stocks
  • Large, small, or medium-sized companies
  • Government or corporate bonds
  • Foreign government debt
  • Real estate investment trusts
  • Specific sectors (healthcare, utilities, or technology, for example)
  • Alternative strategies (buffers, commodities, leverage, etc.)
  • And more

You can probably build a portfolio with the risk level and other characteristics you want.

You can also use single-fund solutions. For example, you might use asset allocation funds for conservative, moderate, or aggressive investors. But look carefully at how those funds work and use extra care when investing in taxable (non-retirement) accounts.

Differences Between Mutual Funds and ETFs Highlighted

While you can accomplish many of the same things whether you use an ETF or a mutual fund, there are some critical differences to consider.

Buying and Selling

A primary difference is how you trade.

With mutual funds, you buy newly-created shares directly from the fund sponsor. When you sell, the fund sponsor buys (or “redeems”) your shares for the current market value.

With ETFs, you typically buy and sell shares in the open market. Put another way, ETFs trade like stocks. You’re generally buying shares from somebody else at whatever price they’re willing to accept.

Trading times: Your mutual fund trades typically occur only once per day at market close (4 p.m. Eastern on most business days). ETFs trade throughout the trading day (or “intraday”).

Dollars or shares? With ETFs, you generally trade shares. You specify the number of shares to buy or sell, and the resulting dollar amount depends on the share price when your trade executes. With mutual funds, you can buy and sell in dollars. For example, you might request to sell $2,500 of a mutual fund, and you don’t need to worry about how many shares this represents. Some platforms make it easier to trade ETFs, but mutual funds are simplest.

Automation: With mutual funds, it’s easy to automate buying, selling, and exchanging. For example, if you’re taking income from your investments, you might request a sale of $2,000 per month, with the proceeds sent directly to your bank. With ETFs, you often need to log in to your account and manually enter an order (specifying the trade size) every time you buy or sell. Again, this is evolving.

Order types: Because ETFs trade like stocks, they involve various order types. You might choose to enter a market order, or you might opt for limit orders or other options. This means you must understand all the different order types if you use ETFs, and many people don’t care. Fortunately, most people don’t need to know all of that.

Trading cost: When trading a mutual fund with the fund sponsor, you might not pay any transaction fees, assuming you use no-load funds. But you might pay transaction charges when you use a brokerage account to buy or sell a mutual fund from a different fund family (for example, buying a Vanguard fund at Fidelity). When it comes to ETFs, you can often trade without transaction costs (or zero commissions), but be sure to check before you trade.

Minimums: Some mutual funds require you to meet minimum purchase levels before you invest. For instance, you might need to invest at least $3,000 in a taxable account or $500 in an IRA. That can be tough when you’re starting out. But a workaround is to build up those funds in cash over several months and then invest. Plus, some mutual funds have no minimums or very low minimums. With ETFs, you can buy one share (or less, when fractional trading is allowed), potentially enabling you to put money to work more quickly.

With small amounts, a delay of several months might not make a significant impact on your big-picture finances. But it can feel good to start building momentum quickly.

Internal Costs

The costs for both mutual funds and ETFs can be all over the board. It’s possible to find inexpensive options either way, and you can also find higher-cost funds.

For a given investment strategy, costs are often (but not always) comparable. For example, a total market index fund from a given issuer might have a similar expense ratio whether you use a mutual fund or ETF.

That said, mutual funds can have additional costs (even with passive index funds), including:

  • Sales loads or commissions, which might be around 5.75% of your initial investment
  • Ongoing distribution fees (12b-1 fees), which might be 0.25% to 1% annually

Those are just examples of the most common fees, and other fee structures may exist.

Market Factors

Because ETFs trade like stocks, they can behave in unexpected ways. You might think that the share price would always equal the value of the investments inside of the fund. But that’s not necessarily the case.

Distortions: With ETFs, market forces can cause the trading price to differ from the value of the fund’s underlying investments. If there is significant demand for ETF shares, for example, the trading price of the ETF might be higher than the value of the fund’s holdings. That’s great if you’re selling, but not so great if you’re buying.

Spreads: When trading on exchanges, buyers and sellers need to agree on a price. In many cases, there’s a difference between what sellers are asking and what buyers are offering. That bid/ask spread can introduce an additional “cost” into trades.

Tips: To avoid the worst distortions and costs from spreads, plan your trading accordingly:

  • These issues might be most prevalent in the 30 minutes or so at market opening and closing hours.
  • Major economic and geopolitical news can cause these issues to increase.
  • Widely held ETFs (like a popular total market index) are less likely to have problems than esoteric or thinly-traded issues.

You might not be able to avoid problems—even with those tips—so speak with a broker at your favorite financial firm to learn more.

The fact that ETFs allow for trading throughout the day isn’t necessarily an advantage. Mutual funds might be all you need if you’re a long-term investor who ignores day-to-day fluctuations.

Taxes

ETFs can be more tax efficient than mutual funds. But that doesn’t necessarily make them a clear winner. When your money is in a tax-deferred account like an IRA or 401(k), distributions and tax treatment become far less important. But taxation could matter more if you have significant holdings in taxable accounts like individual and joint accounts.

The tax difference might change in the future. For example, Vanguard uses a structure that made their mutual funds unusually tax-efficient. The solution was patented and unique to Vanguard, but that patent expired in 2023. We might see other fund companies employ the same strategy, but who knows?

  • Important: This is not a suggestion to use or avoid Vanguard products. It’s simply an example of one fund company’s attempt to equalize the tax burden of ETFs and mutual funds.

Index Investing

Both mutual funds and ETFs can be index funds. There is no clear advantage to choosing one over the other if you want to pursue basic indexing strategies.

Index investing, also known as “passive” investing, involves buying a broad mix of investments without selecting specific companies or issuers.

With indexing, you often buy the market instead of picking individual stocks based on your expectations for how they’ll perform. The idea is to get exposure to certain areas of the market without worrying about which companies will outperform or underperform.

The term “passive” might sound like a bad thing. You may have learned that effort often leads to results, but that’s not always the case with investing.

We might use the analogy of a burning building, where it makes sense to say, “Don’t just stand there—do something.” But sometimes, it makes sense to say the opposite with investing: “Don’t just do something—stand there.” You might come out ahead by letting the markets do their thing and sitting on your hands.

There are several advantages to index investing strategies:

  • Cost: Passive investments tend to have the lowest ongoing costs because you don’t pay for active management. Plus, trading is minimal, which keeps trading costs low. Cost is an important determinant of a fund’s performance.
  • Tax efficiency: Passive investments typically do not trade as frequently as actively managed funds. As a result, you’re less likely to have unwanted capital gains, but surprises can always happen.
  • Performance: With index funds, you should more or less match what the underlying index does. You’re unlikely to underperform significantly with a fund that attempts to follow the market.

Index funds seem to have respectable performance relative to actively managed funds. In fact, research suggests that over the long term, passive strategies would have outperformed the majority of actively managed funds in most categories.

While an active fund can certainly outperform—and you’ll see those winners highlighted and celebrated in financial media every year—that doesn’t mean that investors reap all of the benefits. Sometimes, investors pile into those funds after they see that things are going well, and they miss out on the best results early on.

What Is an Index?

Index funds come in a variety of flavors. For example, you can choose funds that invest in broad markets or specific sectors.

An index is just a group of investments that meet certain criteria. For example, the Wilshire 5000 is an especially broad index—it attempts to track the performance of all liquid stocks in the U.S. And you’ve probably heard of the S&P 500, which represents 500 of the largest U.S. companies.

Investing in a fund that tracks the total stock market enables you to essentially “buy the market,” including winners and losers. There are also fixed-income indices, which can offer exposure to bonds and other vehicles.

The simplest approach to indexing might be something like a three-fund portfolio. With that model, you might use the following components for a globally diversified portfolio:

  • Total U.S. stock market index fund
  • International index fund
  • Fixed income index fund

The proportion in each investment depends on your appetite for risk and other factors.

You can also find sector-specific and other creative index funds. It’s important to evaluate which indices you’re investing in along with pros and cons. For example, a healthcare index fund probably does not represent the stock market in general, and it may have higher expenses than a total stock market index fund.

There’s a lot more to say about indexing, but this isn’t really the time.

While a primarily passive approach is generally a good idea, it’s conceivable that you or an asset manager can pick investments that outperform the market. Maybe you’d do better than an index fund over a given time period, especially if you can pick “the next [enter your favorite high-flier here].” The problem is that it’s extremely difficult to pull that off, and it’s even harder to do consistently over long periods.

Also, you need to remember that index funds attempt to match the market—or a segment of financial markets—for better or worse. If investments in the index lose value, a fund that follows the index will also experience losses and volatility. And a given fund might not track the index as closely as you’d hope. With tracking error and expenses, it’s possible to earn less than you’d expect.

Which Is Best?

Index and chill? Passively managed funds are probably a wise default choice for the majority of your long-term investing. By keeping fees low, you reduce drag in your portfolio. Plus, you can participate in broad market movements, and if you believe in long-term growth, it’s hard to do much better than that.

Keep it simple? Mutual funds are probably easiest when you want to minimize the amount of time and brainpower that go into investing. You can set up automatic monthly contributions or income payments, for example. Plus, you don’t need to worry about order types or do any math to convert dollars to shares.

Tempted to trade? The ability to trade ETFs throughout the trading day might tempt you to trade more often than you should. If you believe in long-term investing principles (we’re talking about decades here), buying or selling at market closing time with a mutual fund is probably adequate.

Adding or withdrawing regularly? When you add to your investments or take income on a regular schedule (monthly, for example), mutual funds are probably easiest. Again, you can automate and invest every month without even logging in to your account.

Sizable taxable assets? When you have significant assets in taxable accounts (or non-retirement accounts), you might favor ETFs. The difference may be minor, but if you’re particularly tax-sensitive, ETFs would likely improve your chances of minimizing tax costs.

IMPORTANT: This is a high-level overview that omits many details that might be important. There are exceptions, curveballs, and complications for everything you see here—so you need to triple-check before trading. Some risks and disadvantages are ignored here, but you should not ignore them, so you need to do more research. Some opportunities/advantages are ignored here, but you should not ignore them. You can and will lose money investing, which may prevent you from reaching financial goals or having the resources you need. You may face tax surprises and other unwanted events regardless of what type of investment you use. To manage those events, do not rely solely on this oversimplified information. Instead, do significantly more research or work with a professional who is familiar with your individual circumstances. This is not individualized advice, as it is presented with zero knowledge of your specific circumstances. You cannot invest directly in an index, and index funds (like other funds) have costs that reduce net returns. Read a prospectus carefully before investing. This stuff is too important to take shortcuts.