Exchange-traded funds, or ETFs, and mutual funds are often used interchangeably because they share so many similarities and can accomplish the same crucial investment goal: diversifying your portfolio.
Both enable investors to purchase a basket of assets, usually a mix of stocks and bonds, that were selected by teams of expert investors. But there are significant differences between ETFs and mutual funds.
For starters, during regular trading hours for U.S.-based stock exchanges, you can purchase any ETF for whatever price it’s trading at, just like with stocks. But with mutual funds, you have to wait until markets are closed to buy or sell them because that’s when their net asset value, a metric that represents the commutative value of all the assets in the fund, is calculated.
Consider the following hypothetical example:
There’s a supermarket delivery service that offers customers two different weekly subscription options. Under the first option, your weekly order will be based on what the typical American household buys, which rarely changes over time. You can’t make substitutions or remove any goods that you don’t want. Total cost: $90 a week. And there is no minimum weekly subscription.
Under the second option, you can select a category that best suits your dietary needs. So if you’re vegan you don’t have to worry about getting stuck with chicken breast. And as new products are introduced or certain items go on sale, the person who oversees shopping lists will make adjustments. Total cost: $175 a week, and you must commit to at least an eight-week subscription.
The first option in a very basic sense is akin to an ETF. ETFs typically are built based on what’s included in a major index like the S&P 500 or a subindex like S&P 500 consumer staples. Because they track indexes, the composition of ETFs typically change only when indexes do, which isn’t often.
On average, index-tracking ETF fees shake out to 0.18% of your investment annually, according to a 2021 report published by the Investment Company Institute, (ICI), an investment industry association. So if you put in $1,000, you’d pay $18 in fees.
That’s significantly smaller than the 0.50% fee on average for investing in an equity mutual fund. In that case, if you invested $1,000, you’d pay $50 in fees. Mutual funds, if you haven’t already guessed, are similar in a basic sense to the second option in the shopping example.
In both cases, you’re required to pay the fees regardless of how the fund or ETF performs.
So what justifies the higher fees for mutual funds?
Level of customer service
Mutual funds tend to have higher fees than ETFs because they are often actively managed by a fund manager. This means that a team of investment experts keep close tabs on the fund’s performance and trade securities based on what they believe will generate the best return for investors.