How do ETFs compare with mutual funds?

 

ETFs and mutual funds tend to share more similarities than differences. In fact, with the exception of their trading flexibility, most ETFs—like mutual funds—are regulated by the Investment Company Act of 1940 and share many of the same characteristics.

 

Similarities between ETFs and mutual funds

Pooled investment vehicles

At their core, ETFs and mutual funds are investment vehicles that gather money from many investors and use it to acquire stocks, bonds, or other assets. This means they serve the same general purpose: To provide access to a particular investment exposure, while also offering the benefits of diversification, economies of scale (trading and operating costs are spread over many investors), professional money management, and convenience.

Diversification

By pooling money together from many investors, ETFs and mutual funds have greater buying power, enabling them to buy many different securities in large quantities. This results in greater diversification than an investor can achieve on his or her own. ETFs, like mutual funds, can also provide diversified exposure to virtually any segment of the market, in the United States and internationally.

Regulation

All mutual funds, as well as the vast majority of ETFs, are subject to strict regulations under the Investment Company Act of 1940. The regulations that govern 1940-Act ETFs and mutual funds include: limitations on borrowing, short sales, and leverage; restrictions on transactions with affiliates independence of board; and segregated custody of fund assets.

Learn more about ETF regulation

Transparency

Compared with actively managed funds, index ETFs and index mutual funds are extremely transparent. Investors have a good sense of what the holdings are and in what amounts based upon the target index, particularly when a full replication strategy is used to track the index.

Learn more about how ETFs are indexed

 

Differences between ETFs and mutual funds

Trading flexibility

An order to buy and sell ETF shares is executed throughout the trading day at market-determined prices that change continually. On the other hand, an order to purchase or redeem mutual fund shares is executed at the end-of-day price, known as net asset value.

Learn more about common ETF order types

Automatic investing flexibility

While ETFs offer more trading flexibility, mutual funds offer more flexibility when it comes to automatic investing services. Mutual funds typically provide automatic investing and withdrawal services that link directly to investors' bank accounts, services that ETFs typically do not provide.

Costs

While ETFs and mutual funds have some costs in common, ETFs include unique costs not associated with mutual funds.

Operating expenses | more

Similar to mutual funds, ETFs charge fees to cover operating expenses, such as advisory services, administration, and recordkeeping, among other things. These fees are expressed as a percentage of fund assets and are commonly known as an expense ratio.

ETFs tend to have lower expense ratios than mutual funds. This is largely due to the fact that most mutual funds are actively managed and charge higher expense ratios than their index counterparts. As the vast majority of ETFs are index funds, on average, their expense ratios are lower than traditional mutual funds.

Another reason ETFs can sometimes offer lower expense ratios is that ETFs do not incur as many costs to maintain shareholder records, while mutual funds must keep and maintain a record of each individual shareholder.

Commissions and sales loads | more

Unlike mutual funds, ETFs are bought and sold and typically there are charges associated with this service. These charges can be in the form of a flat transaction fee or a fee assessed on an investor's total account balance. Some mutual funds charge sales loads, which are similar to brokerage commissions in that they compensate the broker who sold the fund. Sales loads are typically expressed as a percentage of fund assets.

Bid-ask spread | more

When buying or selling ETF shares on the secondary market, there is a difference between the price a dealer is willing to pay for an ETF share (the "bid") and the somewhat higher price the dealer will accept to sell that ETF share (the "ask"). As a result, an investor will typically buy ETF shares for slightly over "market" price and sell for slightly less.

Bid-ask spreads are typically lower for ETFs that are heavily traded or own securities that are highly liquid. Mutual fund shares do not incur bid-ask spread costs, as all trades are transacted at NAV at the end of the day.

Premium/discount volatility | more

ETF shares are designed to trade on the secondary market at a market price that approximates the market value of the ETF's underlying assets. Typically, the market price of an ETF's shares is slightly higher (a "premium" to) or lower (a "discount" to) than the market value of the ETF's underlying assets.

Keep in mind, it is the change in premium or discount that affects an investor's returns, not the level of premiums and discounts—for example, if an investor buys shares at a premium and later sells at a discount. There are no premiums and discounts associated with mutual fund shares, as they trade only at NAV, once a day.

Learn more about premiums and discounts

Tax efficiency

The tax efficiency of an investment product generally has more to do with how it is managed—index versus active—than whether the product is structured as an ETF or mutual fund. The same tax rules apply to ETFs and mutual funds.

Indexing typically tends to result in lower capital gains distributions, given that there tends to be less turnover in an indexed portfolio than in a comparable actively managed portfolio.

Since most ETFs are index-based products, and most mutual funds are actively managed products, the ETF structure tends to be associated with greater tax efficiency, but this tax efficiency in substantial part is a result of having low turnover. In addition, there is the possibility for ETFs to be somewhat more tax-efficient than their index mutual fund counterparts because of the in-kind redemption process.

All investing is subject to risk, including possible loss of principal.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

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