Mutual Funds vs ETFs: What investors should know

The real differences between these fund cousins, however, aren’t as stark. Yes, unlike mutual funds, ETFs trade on an exchange all throughout the day. But beyond that, ETFs are just mutual funds with a few extra features.

So, what’s the big deal? Here are answers to common questions about the two types of fund investments.

What are these funds to begin with?

Mutual funds and ETFs are both baskets of stocks, bonds or other securities that allow individual investors to participate in the market without being at the mercy of a single security. There could be a few dozen stocks in a particular fund, or thousands. Some funds merely try to match the market, so you’ll be riding along with Wall Street’s overall gains or losses, while others target specific sectors (like tech stocks), which could zoom or drop apart from the overall market. Some funds are even highly leveraged (you’ll see 2x or 3x in their names), which ramps up the risk.

The modern mutual fund has its roots in the 1929 stock-market crash. Among the corrective legislation birthed by the ensuing financial crisis was the Investment Company Act of 1940, which established rules for mutual funds.

Mutual funds held $21 trillion (both stock and bond funds) through April, while exchange-traded funds held $6.2 trillion, according to the Investment Company Institute. (Both types of funds are regulated by the Securities and Exchange Commission.)

Who controls the investments?

Ultimately, the investment direction of funds is guided by a portfolio manager, working at an asset manager like Fidelity Investments or BlackRock, or a financial advisory firm. Managers, meanwhile, are overseen by a board of directors that ensures that the product is being managed according to its stated mandate, that fees are reasonable, and its valuation is accurate.

What do they cost?

The baseline cost of an ETF or mutual fund is its expense ratio, the effective annual fee charged to the fund for investment management and administration. And that cost depends heavily on which investment strategy the fund uses: active—whereby the portfolio manager selects securities based on valuation, momentum or other traits—or passive, in which the fund is expected to hew to an index, such as the S&P 500.

ETFs often have lower expenses than mutual funds, because they tend to be passive and so don’t require the research that comes with active management. Mutual funds that are passive also tend to have lower expenses than their active counterparts.

For example, the asset-weighted average expense ratios for all stock-index mutual funds and ETFs were 0.06% and 0.18%, respectively, at the end of 2020. Compare that with an expense rate of 0.71% for active equity mutual funds, according to the Investment Company Institute.

What about performance?

Nothing has upset the apple cart of the fund industry more in the past few decades than the rise of low-cost indexing. According to S&P Dow Jones Indices, 86% of U.S. equity funds underperformed their benchmark over the 20-year period ended Dec. 31, 2020. While index funds—in part because of expenses—don’t tend to return as much as their index, they definitely limit the chance of significant underperformance.

The ready availability of low-cost index ETFs for multiple asset classes, sectors and styles has driven flows to these funds. ETFs have gathered $1.9 trillion over the past five years, compared with $1 trillion in outflows from mutual funds (excluding money-market funds, which are considered a cash holding).

How do I buy a mutual fund

Mutual funds are bought directly from the fund company or through an intermediary, like a financial adviser or brokerage account. This purchase may include a transaction fee, a sales load—that is, a charge based on the amount purchased or held—and a 12b-1 fee, which is earmarked for marketing and distribution. But, thanks to the rise of ETFs, which have no loads and require only a brokerage account for buying and selling, no-load mutual funds have tripled in assets ($15 trillion) over the past 10 years, while funds with a sales load were flat ($2.5 trillion). The price is called the net asset value (NAV) per share, and the money or shares are generally posted to your account the next day.

How do I buy an ETF?

ETF trading is done only through a brokerage account and, like any securities trading, has its pitfalls. For instance, market orders to buy or sell at the prevailing price often are safe for large, liquid ETFs. But this can backfire in thinly traded products, which can be more susceptible to big price swings. Understanding limit-order types—in which you set parameters for the price and amount you are willing to buy or sell—is critical for ETF investors.

It is also important to bear in mind that trade settlement for ETFs, like other listed securities, is two days, while for mutual funds it is one day.

My 401(k) doesn’t offer ETFs. Does that matter?

Despite the fast growth of ETFs, a big reason that their assets still trail mutual funds is that ETFs aren’t common in retirement accounts. Mutual funds remain one of the dominant options there for a variety of reasons. For instance, it is easier for the 401(k) plan to move money into funds—and investors often park that money in a fund and keep it there.

Do ETFs have NAVs?

ETFs, confusingly, have two “prices." The first “price" is the price of shares trading on stock exchanges. The second “price" is the NAV, like regular mutual funds, yet the only investors who have access to the NAV are brokers known as authorized participants. These middlemen pay attention to small differences between the trading price and the value of a published basket of securities that the fund is willing to accept each day in exchange for new shares. If there is high demand for an ETF, its shares might be marginally more expensive than the basket (think pennies). In this case, the authorized participant would sell shares short in the market, while exchanging the basket of securities for new shares of the ETF (which are then used to close the short position). This activity keeps the trading price and the NAV of the ETF in line.

Are ETFs better for taxes?

They share some similarities with mutual funds. Dividends from ETFs are treated no differently than dividends from mutual funds for tax purposes. And index investments, whether ETFs or mutual funds, have historically distributed relatively little capital gains. But there’s one difference in that ETFs by their nature may experience smaller capital gains. The manner by which ETF shares are created and redeemed increases the cost basis of the underlying securities—minimizing any potential capital gains if and when the fund needs to actually sell assets. Potentially, individual investors could have a smaller capital-gains bill in an ETF than in a comparable mutual fund.

My adviser says ETFs are better. Is that true?

Not necessarily. Low-cost index products allow investors to take more control over their portfolio’s risk-and-return profile. With the elimination of ETF commissions at many brokerages, using ETFs for this type of investing has only become easier, whether through financial advisers or automated investing platforms. In fact, asset-management behemoth BlackRock predicts that 50% of ETF flows in the coming years will be driven by automated models.

Yet simple portfolios of mutual funds (or even just one fund) can end up being both cheaper and easier to manage than a portfolio of ETFs, which require trading and have more complex settlement.

What’s next?

Mutual funds and ETFs have had a good run. But just as ETFs brought out doomsayers on the demise of the traditional mutual fund, a new generation is predicting the demise of funds altogether. They point to new technology that allows investors to buy fractional shares of stock or build their own “index fund"—by easily buying lots of stocks in an index directly.

But what they often don’t account for are all of the other complications that go with investing—taxes, accounting, and voting on corporate actions such as mergers and other proxy issues. These are all activities that add time (and headaches) to the investment process—and exactly what funds and ETFs are built to handle.

Mr. Weinberg is a writer in Connecticut. He can be reached at reports@wsj.com.