ETFs vs. Mutual Funds. What's the Difference and Which is Right for You?

Diversification—the strategy of reducing volatility by owning a variety of investments with different characteristics—is a very important step in building your portfolio. However, for those who live busy lives, the task of individually purchasing hundreds or even thousands of stocks to effectively diversify their portfolios can be quite daunting. That's where ETFs and mutual funds come in. Think of both ETFs and Mutual Funds as professionally managed "buckets" or "pools" filled with individual stocks or bonds. Because both include so many different assets, when one potentially goes down, it's safe to say that others are going up, thus reducing risk. This becomes especially handy when investing for the long-term.

So, what's the difference?

While both ETF's and Mutual funds can be valuable tools when building a long term portfolio, there are some key differences. Let's break them down.

How ETFs are managed

While technically they can be either actively or passively managed, generally speaking, ETFs are passive. Instead of being actively managed, it is most typical for an ETF to be designed to mirror the performance of a particular index. Some popular ETFs are the Vanguard S&P 500 ETF (VOO), which tracks the S&P 500, and Invesco QQQ Trust Series I (QQQ), which tracks the Nasdaq-100.

How Mutual Funds are managed

Rather than tracking an index like ETFs, most mutual funds are actively managed by a professional, with the goal of outperforming a market index. Some popular mutual funds include the American Funds Growth Fund of America (AGTHX), which contains large-cap growth companies, and the T. Rowe Price Blue Chip Growth Fund (TRBCX), which invests in established, high-quality companies. Both are actively managed.

How ETFs are bought & minimum investment

ETFs trade like stocks, so you don’t need to have any amount of capital or meet any special requirements to purchase one. Fractional shares are offered by most brokerages, making ETFs very accessible. Additionally, because they trade like stocks, you can purchase them whenever you want.

How Mutual Funds are bought & minimum investment

Mutual funds usually have a higher barrier to entry than ETFs. Many funds require a minimum investment amount. This minimum can range from hundreds to thousands of dollars depending on the fund. In contrast to ETFs, Mutual funds are valued at the end of each day and can only be bought then.

Cost of ETFs

ETFs are known for their low expense ratios—how much you'll pay over the course of a year to own a fund, expressed in a percentage of your investment. The expense ratio for ETFs is typically between 0.03% and 0.50%. In addition to the expense ratio, you might also pay a commission fee when buying or selling ETFs since they're traded like stocks. However, most brokerages now offer commission-free trading for ETFs.

Cost of Mutual Funds

Remember how unlike ETFs, mutual funds are typically actively managed? Well, that comes with a higher cost. Expense ratios are charged by the fund to cover its operating expenses, so naturally the cost will be higher when the fund is being managed more intensively. For mutual funds, expense ratios can range from 0.50% to 1.5% or more, depending on the fund and the manager’s strategy. Additionally, some mutual funds charge sales loads (fees paid when buying or selling shares), though many funds, such as "no-load funds," avoid these fees.

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Let us know which fund you think is right for YOU in the comments down below!