ETFs vs Mutual Funds: Knowing When to Choose Which

This article explores reasons to own ETFs vs mutual funds. 

Between stocks, mutual funds, exchange-traded funds (ETFs), and alternative assets, we now have countless ways to invest our money more than ever.

Though more options are better overall, the choices can be overwhelming.

About 7,400 mutual funds and 3,000 ETFs are listed in the U.S., making it challenging to select the right one. 

Which fund type makes the most sense, and when? How do we narrow the list from thousands to a handful?

DRIPs → Mutual Funds → Stocks → ETFs

When I started investing in 1995, I didn’t have enough money to own mutual funds due to minimum investment thresholds. I relied on dividend reinvestment plans (DRIPs) as the only investing option for someone with just $25 to invest each month.

I started owning mutual funds when I started my first career gig in 1998. I still own a few of those original funds, and they’re among the best performers in my retirement portfolio.

Mutual funds have existed for over 100 years, but the first ETF (SPY) only started trading in 1993.

It took time for ETFs to gain in popularity and trust. By 1997, there were 19 ETFs, and only 80 by 2000.

The more significant investment hurdle for individuals was trading commissions.

Most brokers charged $5 – $20 per trade until 2019, when Schwab cut its trade commissions to zero in response to the popularity of Robinhood. The move caused an industry avalanche — everyone eliminated trading fees. 

Now that most trades are commission-free and the growth of passive index investing has lowered expense ratios, DIY investors have plenty of low-cost options.

But the mutual fund industry is still riddled with complicated fees, especially if you invest through an advisor. 

ETFs are less opaque. 

I’ve mostly owned individual stocks in my taxable accounts, but I’ve started to rely more on stock and municipal bond ETFs over the past few years to help simplify my financial life.

ETFs are generally a better option than mutual funds in taxable accounts because they are more tax-efficient. But mutual funds are efficient in retirement accounts if investors have low-cost options available. 

Understanding the main differences between ETFs and mutual funds will help you make the best decisions for your portfolio. 

Five Primary Differences Between ETFs vs Mutual Funds

The next five items are the most significant differences between ETFs vs mutual funds. 

There are exceptions to some of these, so be sure to understand the specific investments you own or are considering and how they apply to your portfolio. 

The types of accounts in which investors own investments (retirement vs taxable) may change favorability. Retirement accounts help us avoid or defer taxes but do not let us sidestep fees. 

1. Trade Frequency

Mutual funds trade once daily after the market closes. 

ETFs trade like stocks throughout the day. 

That makes mutual funds more hands-off than ETFs. When you’re ready to buy, place an order, and it will execute after the market closes.

ETFs require a market or limit order during the trading day, which can cause behavioral and emotional mistakes. You can avoid emotional risk by dollar-cost averaging into ETFs via automation or buying at the daily opening price. 

2. Investment Minimums

Mutual funds have varying investment minimums, usually ranging from $500 to $3,000. That’s not a rule but a generality.

Some funds have $0 or $10,000+ minimums, often waived in employer-sponsored accounts or if you set up recurring contributions.

ETFs have no minimum investment amounts. The minimum is one share, or if your broker accommodates fractional share transactions, you can invest pennies into ETFs. 

3. Distributions and Tax Efficiency

Most stock and bond ETFs and mutual funds pay dividends, taxed at a lower rate than earned income in non-retirement accounts.

While both mutual funds and ETFs distribute capital gains to investors, ETFs do so less frequently (5%-7% of ETFs).

In retirement accounts, dividends and capital gains distributions for ETFs and mutual funds do not cause a taxable event.

But in taxable accounts, selling an ETF triggers a capital gain (like stocks), while a mutual fund sale or capital gains distribution will both trigger taxable events.

ETFs’ lower frequency of capital gains distributions and the ability to defer them until a sale makes ETFs a more tax-efficient asset and preferable in taxable accounts. 

4. Reinvestment

Mutual fund companies make it easy to receive and reinvest dividends back into the investment from which it was delivered. They want to keep your money.

I love that my Fidelity mutual funds pay me dividends and get immediately reinvested. That has enabled me to set and forget my investments for the past 25 years. 

ETF dividends are deposited into cash pools like stock dividends. 

Non-mutual-fund brokers have varying policies and ease of use for dividend reinvestment for stocks and ETFs. Most online brokers let investors set up dividend reinvestment back into the same ETFs, or you can pool dividends and invest into one security. 

Fractional share trading makes this possible. Robinhood only added this feature within the past few years. M1 Finance built it into the platform core.

Reinvestment has become less of a distinguisher in the past few years, but ETFs take more effort to set it up. 

5. Fees

Mutual funds generally have higher and more complicated fees than ETFs. Fidelity, one of the largest mutual fund providers in the U.S., admits this openly. 

Long ago, the industry made fees hard to calculate and understand so that advisors could receive compensation and would favor certain mutual funds over others.

Investing through a financial advisor who has you invested in mutual funds makes you more susceptible to hidden or confusing fees.

The rise in popularity of index funds can be tied back to fees. Most actively managed mutual funds do not outperform their benchmark indexes over the long term, in part because fees reduce net performance numbers.

DIY investors have caught on, avoiding excessive fees and underperforming managed funds, choosing index funds instead.

Mutual fund fees include:

• Load: An upfront fee, usually meant to compensate a broker/advisor. 
• 12b-1 Fee: An annual “marketing fee” also going to the brokers. 
• Expense Ratio: Covers operating expenses for the fund. 
• Trading/Network Fees: If you try to buy a Vanguard fund at Fidelity, Fidelity will charge you a hefty fee — and vice versa. The companies want you to stay within their networks, deterring the purchase of outside funds with large fees. Many online brokers, such as Robinhood and M1 Finance, do not offer mutual funds because of these fees. 

ETFs have an expense ratio but do not have loads or 12b-1 fees.

Therefore, when you own an ETF, you can be more comfortable knowing the only fees you pay are in the expense ratio and any trade commissions (if any). 

Many mutual funds do not have loads or 12b-1 fees, but probably not the ones purchased through a financial advisor unless they are a fee-only fiduciary.

DIY investors should avoid funds with loads and 12b-1. These fees are disclosed in the prospectus or on online quote pages. Reject any fund with either fee.

Also, stick with funds from your mutual fund provider to avoid any network fees (If you’re a Fidelity customer, only buy Fidelity funds. Vanguard, only Vanguard, etc). 

If your online broker allows mutual fund investing but charges fees to invest, choose ETFs instead. There are ETF equivalents for nearly all passive mutual index funds. 

When to Own Mutual Funds

Mutual funds are great when the fees are low and transparent. They work best when you have an account with the mutual fund provider and own that provider’s funds. 

Own mutual funds in retirement accounts to reduce the tax burden of dividends and annual capital gains distributions. 

Employer-sponsored plans (e.g., 401(k)s, 403(b)s) often only offer mutual funds. You may have excellent or poor investment options depending on the plan’s quality.

Choose passive index funds instead of actively managed funds. 

If a mutual fund provider does not manage the plan, you might be getting hit with hidden fees. Contact your employer and advocate for low-cost options with no loads or 12b-1 fees if necessary.

They have reason to listen and may not understand their employees are getting fleeced. 

Smaller employers are particularly susceptible. However, companies like ForUsAll and Ubiquity make it possible for small businesses to have high-quality plans without the extra fees. 

My previous employer had a lousy 401(k) that paid exorbitant fees to a large mutual fund provider. It still made sense for me to invest because of the tax deductions, and investing is better than not. However, I’d be wealthier today if my employer had chosen a better plan way back in 2003. 

I transferred that money into an IRA with better funds the first chance I had.

When to Own ETFs

ETFs are usually better in taxable accounts because of mutual fund capital gains distributions.

Owning mutual funds in taxable accounts likely results in higher tax bills, except for mutual funds that do not distribute capital gains (for example, the popular VTSAX no longer distributes capital gains). 

Not all mutual funds have capital gains distributions, but most do. Fewer ETFs have capital gains distributions. 

Use ETFs for more active investment strategies, or if you prefer a more hands-on approach to investing. Also, use ETFs when mutual funds are unavailable in your brokerage account or if there are network or trading fees to own mutual funds. ETFs are far more available. 

If you’re working with a financial advisor and they are using actively managed mutual funds, loaded funds, or funds with 12b-1 fees to manage your portfolio, ask them to switch to ETFs or no-load funds. Warning: they may respond with well-rehearsed gibberish about why you should not. 

How to Narrow ETF and Mutual Fund Choices

I use straightforward criteria to narrow the massive list of mutual funds and ETFs to fit my investment objectives. 

1. Aim Own Mutual Funds Managed by your Broker 

I have a Fidelity account, so I only buy Fidelity mutual funds. 

Aim to do the same if your account is with a mutual fund company. 

Fidelity provides excellent low-cost index funds and doesn’t charge trading, 12b-1, or loads when I buy them. 

The expense ratios are competitively low for index funds compared to Vanguard, Schwab, and Blackrock, giving me numerous ways to achieve investment objectives. 

There are two exceptions in my account. I still own Vanguard funds (VTSAX and VTABX) from a previous employer’s 401(k) and continue to hold the funds and reinvest distributions.

There’s no fee to hold or reinvest distributions, but there would be a $75 fee if I want to buy new shares. I only buy Fidelity funds now to accomplish the same objective. 

In some cases, employer-sponsored plans only offer mutual funds from other providers. You will still benefit from the tax-advantaged account. But if the choices are plagued with high fees, ask your HR department for better options. Offer suggestions.

Use ETFs if your broker is not a mutual fund provider. 

2. Choose an ETF Company and Stick with it

The three largest ETF providers have more than 75% market share of all ETF assets. They are: 

• Blackrock
• Vanguard
• State Street

Choosing just one of these three ETF providers should cover all investment objective needs while weeding thousands of ETFs. 

Of these, I prefer Vanguard. Vanguard offers 84 low-cost ETFs. You can find almost everything you need within those 84 funds. You may need to expand your boundaries if you’re looking to invest in specific commodities or other strategies.

ETF and mutual funds screeners can also help narrow the pool of potential investments.

3. Choose Conventional and Long-Established Index Stock and Bond Funds

ETF innovation has complicated the space by offering leveraged ETFs (e.g., short, 2X long), covered call strategies, currencies, and various commodities. 

Avoid leveraged funds and stick to your investment objectives and age-appropriate portfolio allocation.

Venturing beyond stocks and bonds into commodities like gold, silver, currencies, or the soon-to-be crypto products would add another layer of due diligence. Educate yourself before investing.

Multiple conventional funds can provide market performance, income, growth, or balanced portfolio allocations to fit your investment objectives. Aim for broader diversification and larger funds for ample liquidity. 

Conclusion – ETFs vs Mutual Funds

Over the last 28 years of my investing career, ETFs have grown from nothing to a driving force in today’s markets. 

Though mutual funds are more common and suitable for many investment objectives, industry-established “marketing” compensation still thrives, requiring a veil of skepticism when owning mutual funds. Perform due diligence to avoid excessive fees. Ask your financial advisor hard questions.

Aim to buy mutual funds from your account’s mutual fund provider (or they are the only 401(k) options), and increase your chances of success by selecting broad market passive index funds instead of managed funds. 

Stock and bond index ETFs offer solid building blocks for DIY investors, especially in taxable accounts. The fee structure is more transparent, yet the options are plentiful. 

Overcome the paradox of choice by selecting one ETF provider, and keep your portfolio uncomplicated by owning only a handful of funds.

A downside of ETFs is some investors may not be comfortable purchasing them like stocks, preferring the once-daily trading of mutual funds.

Despite that, many modern online brokers provide automation tools to dollar-cost average and reinvest dividends, making ETFs just as set and forget as mutual funds.

The more our investing tools are hand-off, low-cost, and diversified, the more we can reduce the risk of behavioral mistakes and enjoy long-term compounding. 
Featured photo via DepositPhotos used under license.