For most of the twentieth century, the mutual fund was the default vehicle for ordinary investors. The exchange-traded fund, or ETF, did not exist before 1993 and did not become widely held until the early 2000s. Today, ETFs account for more than $7 trillion in U.S. assets, according to the Investment Company Institute, and have grown at roughly four times the pace of mutual funds for a decade. The two structures hold essentially the same underlying investments and produce essentially the same returns when they track the same index. The differences are practical: how they trade, how they are taxed, what accounts they fit into, and how much they cost. For most investors, the choice between them comes down to a handful of features rather than a philosophical preference.
What is the structural difference?
Both ETFs and mutual funds pool investor money to buy a diversified basket of securities, and both are regulated under the Investment Company Act of 1940. The mechanical difference is in how shares are bought and sold.
Mutual fund shares are priced once per day, after the market closes, based on the fund’s net asset value. Orders placed during the day are filled at that closing price. Buying or selling happens directly with the fund company.
ETF shares are listed on a stock exchange and trade throughout the day at prices that fluctuate slightly around the underlying net asset value. Buying or selling happens through a brokerage account, just like a stock. A network of authorized participants continuously creates or redeems large blocks of ETF shares in exchange for the underlying securities, which keeps the market price closely aligned with the value of the holdings.
That structural difference, called in-kind creation and redemption, is the source of most of the practical advantages ETFs hold over mutual funds.
How do costs compare?
The asset-weighted average expense ratio for ETFs in 2022 was 0.16%, compared with 0.44% for mutual funds, according to Morningstar’s annual fund fee study. The gap is partly explained by the fact that most ETFs are index funds, which are cheaper to run than active funds, but even on an apples-to-apples basis ETFs tend to be slightly cheaper than equivalent index mutual funds at the same provider.
Some mutual funds, particularly those purchased through financial advisors, also carry sales loads of 1% to 5%, deducted from the initial investment. Front-end loads on A-share funds and back-end loads on B-share funds are increasingly rare, but still exist. No ETF charges a sales load; the only direct cost beyond the expense ratio is a small bid-ask spread on each trade, typically a fraction of a cent for popular funds.
What about taxes?
The in-kind creation and redemption process gives ETFs a meaningful tax advantage over mutual funds in taxable accounts. When a mutual fund manager sells securities to meet redemptions, the fund realizes capital gains that are distributed to remaining shareholders at year-end. Investors who held the fund all year, and even invested late in the year, owe taxes on those gains.
ETFs largely avoid this through the in-kind redemption mechanism, which transfers appreciated securities out of the fund without triggering a taxable sale. A 2021 study by ProShares found that the typical equity mutual fund distributed capital gains in 17 of the past 20 years, while comparable equity ETFs distributed gains in fewer than three.
The advantage matters most for investors in taxable accounts and least for those in IRAs and 401(k)s, where capital gains distributions have no immediate tax effect. As the framework in our piece on building an investment portfolio from scratch notes, asset location, which is the decision about which holdings go in which account types, is one of the most overlooked sources of return.
When does a mutual fund still make sense?
Mutual funds remain the better choice in several specific situations. The first is employer retirement plans. Most 401(k) and 403(b) plans offer only mutual funds, including institutional share classes that are not available to individual investors at any price. The expense ratios on these institutional shares can be lower than equivalent ETFs.
The second is automatic recurring investments. Mutual funds support precise dollar amounts at any frequency: $327.50 every two weeks, for example. ETFs increasingly offer recurring investments, but the feature is newer and not yet universal at every brokerage. As discussed in our piece on dollar-cost averaging, the consistency of automated contributions is one of the strongest predictors of long-term success, and mutual funds remain the more reliable vehicle for fully automated investing.
The third is access to certain actively managed strategies that are not available in ETF form, such as some target-date funds and many bond funds. The ETF universe is growing rapidly, but mutual funds still dominate certain niches.
When is an ETF the better choice?
In taxable brokerage accounts, ETFs are usually preferable. The tax efficiency advantage, lower expense ratios, and intraday liquidity all favor the ETF structure. For broad index exposure, an ETF such as Vanguard Total Stock Market (VTI) or iShares Core S&P 500 (IVV) is among the most efficient holdings available.
ETFs also fit better when an investor wants exposure to a specific theme, sector, or geography that may not have a comparable mutual fund. Sector ETFs, factor ETFs, and country-specific ETFs are far more numerous than their mutual fund equivalents.
For tax-loss harvesting, the variety of similar but not identical ETFs makes it easier to sell a position at a loss and immediately buy comparable exposure without triggering the IRS wash-sale rule. Three different total-market ETFs from Vanguard, Schwab, and iShares are similar enough in performance and different enough in tracking index to qualify.
What about ETF-specific risks?
Most well-established ETFs that track broad indexes are very low-risk in terms of structural problems. A handful of risks are worth noting, particularly for less-common products.
Bid-ask spreads on thinly traded ETFs can be wide enough to erode returns. Spreads of 0.10% or more are common in niche or low-volume funds; the largest ETFs typically trade at spreads of 0.01% or less. Using limit orders rather than market orders is a useful habit, especially for smaller or less-liquid funds.
Premiums and discounts to net asset value occasionally widen during periods of market stress, particularly in fixed-income ETFs. In March 2020, several investment-grade bond ETFs traded at discounts of 4% or more to their underlying net asset values for several days. The dislocations corrected, but investors who sold during the spike crystallized real losses.
Leveraged and inverse ETFs carry risks that go beyond what most investors realize. These products are designed for one-day holding periods and produce path-dependent returns that diverge from their advertised exposure over time. They are not suitable for long-term portfolios.
How does the choice fit into a broader portfolio?
For a long-term portfolio, the difference between holding a Vanguard mutual fund and the equivalent Vanguard ETF is small. Both will produce similar returns net of fees, and both will track the same index. The decision matters at the margins: ETFs offer better tax efficiency in taxable accounts, while mutual funds offer cleaner automation in retirement accounts.
A useful default for many investors is to hold ETFs in brokerage accounts and mutual funds in 401(k) or IRA accounts, choosing the lowest-cost option available in each. The split takes advantage of each structure’s strengths without requiring constant attention. Our explainer on what an index fund is covers the broader principles that apply to both vehicles.
Frequently Asked Questions
Can I switch from a mutual fund to an ETF without a tax bill?
In a tax-advantaged account such as an IRA or 401(k), yes; switching between holdings has no immediate tax consequence. In a taxable account, selling a mutual fund with embedded capital gains creates a taxable event. Some providers, including Vanguard, allow tax-free conversions between mutual fund and ETF share classes of the same underlying fund, which is a useful exception worth checking.
Do ETFs pay dividends?
Yes. ETFs that hold dividend-paying stocks pass through the income to shareholders, typically quarterly or monthly. The dividends can be reinvested automatically through a brokerage account or taken as cash. The tax treatment matches the underlying holdings: most U.S. equity ETF dividends are qualified dividends, taxed at the preferential capital gains rate when the holding period requirement is met.
Are ETFs riskier than mutual funds?
For comparable underlying holdings, no. An S&P 500 ETF and an S&P 500 mutual fund carry essentially the same market risk. ETF-specific risks involve trading mechanics and apply mostly to less-liquid or specialty products. Broad index ETFs from major providers are among the lowest-risk equity vehicles available.
What is the minimum to invest in an ETF?
The minimum is the price of one share, which can range from less than $10 for some bond ETFs to several hundred dollars for popular equity ETFs. Most major brokerages now offer fractional ETF shares, allowing purchases of any dollar amount as low as $1. Mutual funds typically require a minimum initial investment of $1,000 to $3,000, although some Schwab and Fidelity index funds have no minimum.
How do I know if an ETF tracks its index well?
Tracking error, which measures the gap between a fund’s return and its benchmark’s return, is the relevant metric. For broad-market ETFs from major providers, tracking error is typically less than 0.10% per year. Tracking error is usually disclosed in the fund’s annual report and on Morningstar’s fund page. Wider tracking errors are common in niche, leveraged, or international ETFs.
Can I hold both ETFs and mutual funds in the same account?
Yes. Most brokerage accounts and IRAs allow any combination of ETFs, mutual funds, individual stocks, and bonds. The two structures coexist easily, and many investors use both. The choice is a matter of which vehicle is most efficient for each specific holding rather than an either-or decision for the whole portfolio.
