ETFs vs Mutual Funds

ETFs and mutual funds both work the same basic way: a lot of investors put money into one pool, and that pool buys a mix of stocks or bonds. ETFs trade all day on the stock market, like a stock, and usually cost less and cost you less in taxes. Mutual funds are priced once a day, after the market closes, and they're what most workplace 401(k) plans use.

A mutual fund (opens in new tab) takes money from a lot of people and uses it to buy stocks, bonds, or both. You own a share of the fund itself, not the stocks inside it directly. Someone, a fund manager, or sometimes just a computer following an index, decides what the fund buys. How much money you make depends on how those holdings do overall, minus the fund's fees.

Mutual fund shares get one price a day, set after U.S. markets close. That price is called the NAV, short for net asset value: add up everything the fund owns and divide by the number of shares. Place an order at 2:00 p.m. and you won't know your exact price until hours later, once the NAV is set. You can't buy or sell mutual fund shares throughout the day the way you can with a stock.

Most mutual funds inside a 401(k) are actively managed: a person picks the stocks, trying to beat the market. That extra work costs more. These funds charge an expense ratio, a yearly fee taken out of the fund automatically, usually 0.50% to over 1.00% of your money. You pay that fee whether the fund beats the market or not, and decades of data show most of them don't beat it once fees are counted.

That's why low-cost index funds, ones that just copy the market instead of trying to beat it, have become the default choice for long-term investors. Most people in a 401(k) should be in one of these. A lot aren't.

An exchange-traded fund (opens in new tab), or ETF, works the same basic way as a mutual fund: it pools money and buys a basket of stocks or bonds. The difference is how you buy and sell it. An ETF trades on the stock market all day long, just like a share of a company. Buy it at 10:00 a.m., sell it at 2:00 p.m., or hold it for 30 years. Its price moves throughout the day based on what it owns and on how many people want to buy or sell it right then.

Most ETFs just copy an index instead of trying to beat it. A broad U.S. stock ETF holds hundreds or thousands of companies, sized to match their real weight in the market. Because there's no manager picking stocks or doing research, these funds are cheap to run. Many index ETFs charge just 0.03% to 0.10% a year, a small fraction of what an actively managed mutual fund costs. Over 20 or 30 years, that gap adds up to real money.

ETFs also tend to owe less in taxes, and here's why. When mutual fund investors cash out, the fund sometimes has to sell its own holdings to raise the money, and that sale can trigger a tax bill for every remaining shareholder, even people who didn't sell anything. ETFs sidestep this with a different behind-the-scenes process for large trades, so you only owe capital gains tax when you personally sell your own shares. In a regular taxable account, that difference is real money over time.

Cost. Index ETFs cost a little less than index mutual funds, and both cost a lot less than actively managed mutual funds. A 0.05% fee versus a 0.75% fee is a 0.70% gap every year. That sounds tiny. But on a $50,000 account held for 20 years, that gap can cost you thousands of dollars by the end. And you pay that fee every year, good markets and bad.

Taxes. In a regular taxable account, ETFs usually cost you less in taxes, for the reason explained above. Inside an IRA or 401(k), it doesn't matter: gains aren't taxed until you withdraw money (traditional) or never taxed at all (Roth), so the tax edge disappears. If you're picking between a similar ETF and mutual fund inside a retirement account, just compare the yearly fee. That's the only real difference left.

Trading. ETFs trade all day like stocks. Mutual funds get one price a day. If you're investing for the long run, being able to trade all day rarely matters. It does make it easier to buy or sell an ETF at an exact price, which helps if you need your money fast.

Minimums. A lot of mutual funds want $1,000 or more just to get started. An ETF costs whatever one share costs, and most brokerages will now sell you a fraction of a share. If you're starting small, ETFs are easier to get into.

In a taxable account, a low-cost index ETF is a solid default choice for owning the broad market. Inside a retirement account, a low-cost index mutual fund works just as well. Both are regulated under a 1940 federal law, the Investment Company Act, that requires them to publish what they own, what they charge, and what they're trying to do, in a document called a prospectus.

The case for paying more for an actively managed fund comes down to one question: can the manager beat the market consistently, after fees? Historically, most can't.

The most important number to compare is the expense ratio, a yearly fee taken directly out of the fund. Index ETFs usually charge 0.03% to 0.20% a year. Actively managed mutual funds often charge 0.50% to 1.50% or more. You pay that gap every year, no matter what the market does.

No-load index mutual funds, ones with no upfront sales fee, have closed most of that gap. A low-cost index fund tracking the S&P 500 can charge as little as 0.03% a year, almost the same as the cheapest ETFs. So picking between the two often comes down to convenience and account type, not just the fee.

ETFs have one extra cost mutual funds don't: the bid-ask spread. Since ETFs trade like a stock, the price you buy at is always a little higher than the price you'd sell at right then. For popular ETFs, that gap is tiny, a fraction of a percent. For ETFs nobody trades much, it can be bigger. It's a real cost, but usually small for the major index ETFs.

A lower fee doesn't guarantee a better result. Both ETFs and mutual funds involve risk, including the possible loss of principal. A cheap fund can still lose money, and an expensive one isn't automatically bad. The fee is one thing to weigh, not the whole decision.

When mutual fund investors cash out, the fund manager sometimes has to sell some of what the fund owns to raise the cash. Selling triggers a taxable gain. That gain gets split among everyone still holding the fund at year-end, even people who never sold anything all year. You can end up owing taxes on a sale you had nothing to do with.

ETFs avoid this with a different process behind the scenes. When big institutional investors cash out of an ETF, they get handed the actual stocks the fund owns instead of cash. Nothing gets sold, so no tax bill gets created for the fund. Everyone else holding the ETF is unaffected. You only owe capital gains tax when you sell your own shares.

Both ETFs and mutual funds pay out dividends and interest to shareholders, and that income is taxed the same way either way. The ETF tax advantage only applies to those surprise capital gains payouts, not to regular income.

Inside a retirement account, this whole tax difference disappears. In a traditional IRA or 401(k), you don't owe tax until you withdraw money. In a Roth IRA, qualified withdrawals are never taxed. Since nothing inside those accounts creates an immediate tax bill, the ETF's tax advantage doesn't help you there.

Tax rules change, and your own tax bill depends on your income, what you own, and how long you've owned it. Talk to a qualified tax professional about your specific situation.

All three Narstar portfolios hold individual stocks and cash, nothing else. We don't use ETFs or mutual funds in any Model Portfolio today, and that's spelled out in our Form ADV Part 2A, Item 4.C. We might add plain ETFs later, and if we do, we'll update that document first. This is a choice we made on purpose, and it comes with real tradeoffs.

An index ETF buys every company in its index, good or bad, expensive or cheap. We don't do that. The Income portfolio holds dividend-paying companies chosen for their cash flow. The Growth portfolio holds companies with durable competitive advantages, real edges over competitors that should hold up over time. The Speculative portfolio holds a small number of smaller, riskier companies. Every stock we hold, we picked for a reason. That's the whole point of doing it this way.

But that focus cuts both ways. Owning fewer, hand-picked stocks means more risk sits in each one. If one holding runs into serious trouble, it hurts the whole portfolio more than it would if that stock were just one of 500 in a broad index. These portfolios can trail the overall market for a long stretch, and they can lose more in a sharp downturn if the companies we hold get hit hard. That's not a bug we're trying to fix. It's how concentrated stock-picking works: bigger swings, up and down.

On fees: for regular taxable accounts, we charge 0.60% a year for Income, 1.20% for Growth, and 1.60% for Speculative. IRAs (Traditional, Roth, Rollover, SEP, and SIMPLE) pay a uniform 1.00% a year regardless of model portfolio mix, billed quarterly in arrears. Individual stock holdings carry no fund expense ratios. Interactive Brokers may charge separate brokerage commissions and fees, including any applicable custody, margin, or other brokerage costs. Use the homepage fee calculator to see the exact dollar amount at your balance.

If what you actually want is broad exposure to hundreds of companies at the lowest possible cost, an ETF through a robo-advisor or your own brokerage account is probably the better fit. See our robo-advisor vs. fee-only adviser article for that comparison. Narstar is for people who'd rather have specific companies picked and managed for them, with a clear fee and an actual person making the calls.

Are ETFs better than mutual funds for taxes?

In a taxable account, yes, usually. When mutual fund investors cash out, the fund sometimes has to sell its own holdings to raise money, and that can create a tax bill for everyone still holding the fund, even people who didn't sell. ETFs avoid this because large trades get settled with actual stocks instead of cash, so no tax bill gets created. Both still tax regular dividends the same way. Inside an IRA or 401(k), this difference doesn't matter at all. Tax rules change, so check with a tax professional about your own situation.

Which is cheaper, ETFs or mutual funds?

Usually ETFs, but it depends which kind. Index ETFs charge as little as 0.03% to 0.20% a year. Actively managed mutual funds often charge 0.50% to 1.50% a year, much more. But a no-load index mutual fund can cost almost the same as a cheap ETF, often just 0.03%. The real cost gap is between any index fund and an actively managed one, not between ETFs and mutual funds as a category.

Are ETFs safer than mutual funds?

No. What's inside decides the risk, not the wrapper. A stock ETF and a stock mutual fund tracking the same index carry the same risk, and both can lose value in a downturn. ETFs are usually cheaper and more tax-efficient in a taxable account. That's a cost difference, not a safety difference.

Which is better inside a 401(k) or IRA?

Most 401(k) plans only offer mutual funds, so that decision is often made for you. Inside an IRA where you can pick either, the ETF tax advantage doesn't matter because nothing gets taxed inside the account anyway. Just pick whichever one charges less. That's really it.

Do ETFs pay dividends?

Yes. When the companies inside an ETF pay dividends, the ETF passes that money on to you, usually every quarter. You can take it as cash or reinvest it. Like any dividend, it's not guaranteed, and it shrinks if those companies cut their payouts.

What's a sales load, and how do I avoid one?

A sales load is an upfront commission built into some mutual fund share classes, often 3% to 5.75% of what you invest, paid to whoever sold you the fund. No-load index funds and ETFs cover every major category, so there's no reason to ever pay one. And a fee-only adviser doesn't earn a commission from selling you a fund, so there's no incentive to put you in one.