ETFs and mutual funds are not the same thing, though both hold a basket of stocks or bonds

An exchange-traded fund (ETF) is a fund that trades on a stock exchange like a single stock does. A mutual fund is a fund you buy directly from the fund company or through a broker, and its price is set once per day after the market closes. Both hold many investments inside them, but the way you buy them, the price you pay, and the costs you bear are different.

The core difference comes down to how the fund itself is bought and sold. When you buy an ETF, you are buying it from another investor on an exchange — the same way you would buy Apple stock. When you buy a mutual fund, you are buying it directly from the fund company, and they create new shares for you. This one structural difference creates a chain of consequences: ETFs usually cost less to own, trade throughout the day at changing prices, and may produce fewer taxable events inside the fund.

Key Takeaways

  • ETFs trade on exchanges during market hours at prices that change minute to minute, while mutual funds trade once per day at a price set after the market closes.
  • ETFs typically charge lower annual fees than mutual funds because they are structured to minimize the fund company's work in buying and selling shares.
  • Mutual funds often require a minimum investment amount, while most ETFs can be bought for the price of a single share.
  • ETFs may generate fewer taxable capital gains distributions than mutual funds, which matters if you hold them in a regular taxable account.

How you buy each one and what it costs

When you buy an ETF, you place an order through a brokerage account just as you would to buy a stock. You see the price in real time, you can place a limit order (buy only if the price drops to a certain level), and the trade settles in two business days. You pay a commission to your broker if they charge one, though many brokers now offer commission-free ETF trades.

When you buy a mutual fund, you send money to the fund company or through a broker that sells that fund. The fund company calculates the price once per day, after 4 p.m. Eastern Time when the stock market closes. You do not see the price until the next morning. You cannot place a limit order or buy at a specific price — you get whatever the closing price was. Many mutual funds charge a sales load, which is a commission paid to the broker or advisor who sold it to you, ranging from 0% to 5.75% depending on the fund.

The annual fee you pay to hold the fund is called the expense ratio. ETFs typically charge 0.03% to 0.50% per year, while mutual funds typically charge 0.50% to 1.50% per year. On a $10,000 investment, that difference is $50 to $100 per year. Over decades, that compounds.

Price discovery and trading throughout the day

Because ETFs trade on an exchange, their price moves during the trading day. If you own an ETF and the stocks inside it rise in value, you can see that reflected in the ETF price within seconds. You can sell at any point during market hours if you need the money or want to lock in a gain. You can also use advanced order types: buy only if the price drops to $50, or sell only if it rises to $52.

Mutual fund prices are fixed once per day. If you place an order to buy or sell a mutual fund at 2 p.m., you will get the price that is calculated at 4 p.m. — you do not know what that price will be. This can be an advantage if the market is falling and you want to sell (you might get a better price than you see right now), or a disadvantage if the market is rising. You cannot use limit orders or any other trading strategy that depends on intraday price movement.

Minimum investments and account size

Most ETFs can be bought for the price of a single share. If an ETF is trading at $75 per share, you can buy one share for $75. This makes ETFs accessible to investors with small amounts of money to start with.

Many mutual funds require a minimum initial investment of $1,000 to $3,000, and some require $10,000 or more. If you have $500 to invest, you cannot buy that mutual fund at all. Some funds waive the minimum if you set up automatic monthly contributions, but not all. This requirement exists because mutual funds have higher administrative costs per investor.

Tax consequences inside the fund

When a fund manager buys and sells stocks inside the fund, those trades can create capital gains. If the fund sells a stock for more than it paid, that is a gain. At the end of the year, the fund distributes those gains to its shareholders, and you owe tax on them — even if you did not sell the fund itself and even if you reinvested the distribution.

ETFs are structured in a way that minimizes these distributions. The mechanism is technical (it involves "in-kind" creation and redemption of shares), but the result is that ETFs typically distribute far fewer capital gains than mutual funds. This matters most if you hold the fund in a regular taxable account. In a tax-deferred account like a 401(k) or IRA, the distributions do not trigger tax anyway, so the advantage disappears.

Actively managed mutual funds — those where a manager picks individual stocks — tend to trade more frequently and generate more capital gains. Index mutual funds and index ETFs, which straightforward hold all the stocks in an index and rarely trade, generate fewer gains. The tax advantage of ETFs is largest when you compare an actively managed mutual fund to an index ETF.

Active management versus index tracking

Both ETFs and mutual funds come in two varieties: actively managed and index-based. An actively managed fund pays a manager to pick which stocks or bonds to hold, trying to beat the market. An index fund straightforward holds all the stocks in a chosen index, like the S&P 500, and tries to match the market's return.

Actively managed mutual funds are more common than actively managed ETFs, though both exist. Index ETFs are extremely common and very cheap to own — many charge 0.03% to 0.10% per year. Index mutual funds are also available and are cheaper than actively managed mutual funds, but they still usually cost more than index ETFs.

The choice between active and index is separate from the choice between ETF and mutual fund. You can own an actively managed ETF, an index ETF, an actively managed mutual fund, or an index mutual fund. The structure (ETF or mutual fund) and the strategy (active or index) are two different decisions.

When each one makes sense for your situation

ETFs work well if you have a brokerage account and want low costs, the ability to trade during the day, and a small amount of money to start with. They are also the better choice if you hold investments in a taxable account and want to minimize capital gains distributions.

Mutual funds work well if you prefer to set money aside and not watch prices, or if you are buying through an employer retirement plan like a 401(k) — most 401(k) plans offer only mutual funds, not ETFs. Some people also prefer the simplicity of a fixed daily price and the inability to trade intraday, because it removes the temptation to trade too often.

If you are choosing between an actively managed mutual fund and an index ETF, the ETF will almost certainly cost less and generate fewer taxable gains. If you are choosing between an index mutual fund and an index ETF, the ETF will cost less, but the mutual fund may be available inside your 401(k) when the ETF is not.

Frequently Asked Questions

Can I buy an ETF inside a 401(k) or IRA?

It depends on the account. Most 401(k) plans offered by employers hold only mutual funds, not ETFs. IRAs opened at a brokerage firm can hold ETFs. If you have a self-directed IRA or a brokerage IRA, you can buy any ETF that trades on a U.S. exchange. Check with your account provider to confirm what investments are available in your specific account.

Do ETFs pay dividends like stocks do?

Yes. If the stocks or bonds inside an ETF pay dividends or interest, the ETF collects that money and distributes it to shareholders, usually once or four times per year depending on the fund. You can take the dividend as cash or reinvest it to buy more shares. Mutual funds work the same way.

What happens if the ETF company goes out of business?

If an ETF closes, your shares do not disappear. The fund company must liquidate the holdings (sell all the stocks inside) and send you the cash proceeds. This can take a few weeks. Your investments are protected by the same rules that protect mutual fund investors — the fund company holds your shares in trust and cannot use them for its own business.

Are ETFs riskier than mutual funds?

The risk depends on what is inside the fund, not on whether it is an ETF or a mutual fund. An ETF that holds 500 large U.S. stocks has the same risk as a mutual fund that holds the same 500 stocks. The structure (ETF or mutual fund) does not change the risk of the investments themselves.

Can I lose money in an ETF or mutual fund?

Yes. Both ETFs and mutual funds own stocks or bonds, and the value of those investments can fall. If the stocks inside the fund drop 20%, your fund drops 20%. The fund structure does not protect you from market losses. Diversification inside the fund reduces risk compared to owning a single stock, but it does not eliminate it.