ETFs vs. Mutual Funds: Which To Choose | Vanguard (2024)

FAQs

Why choose an ETF over a mutual fund? ›

ETFs usually have to disclose their holdings, so investors are rarely left in the dark about what they hold. This transparency can help you react to changes in holdings. Mutual funds typically disclose their holdings less frequently, making it more difficult for investors to gauge precisely what is in their portfolios.

If you're paying fees for a fund with a high expense ratio or paying too much in taxes each year because of undesired capital gains distributions, switching to ETFs is likely the right choice. If your current investment is in an indexed mutual fund, you can usually find an ETF that accomplishes the same thing.

Because of their wide array of holdings, ETFs provide the benefits of diversification, including lower risk and less volatility, which often makes a fund safer to own than an individual stock.

ETFs have transparent and hidden fees as well—there are simply fewer of them, and they cost less. Mutual funds charge their shareholders for everything that goes on inside the fund, such as transaction fees, distribution charges, and transfer-agent costs.

Although similar to mutual funds, equity ETFs are generally more tax-efficient because they tend not to distribute a lot of capital gains.

As with traditional investment funds, ETFs have to place their underlying investments with a custodian. The fund provider cannot be both the fund manager, and the "guardian" of the assets. So if an ETF provider goes bankrupt, your investments are not gone cause they will still be kept by the custodian.

An index fund is a type of mutual fund that tracks a particular market index: the S&P 500, Russell 2000, or MSCI EAFE (hence the name). Because there's no original strategy, not much active management is required and so index funds have a lower cost structure than typical mutual funds.

Holding an ETF for longer than a year may get you a more favorable capital gains tax rate when you sell your investment.

If a fund consistently underperforms over multiple periods and fails to deliver satisfactory returns, consider exiting the investment. Research and select funds with a similar investment objective but better track records and performance history to redirect your investments.

Do you pay taxes on ETFs every year? ›

For most ETFs, selling after less than a year is taxed as a short-term capital gain. ETFs held for longer than a year are taxed as long-term gains. If you sell an ETF, and buy the same (or a substantially similar) ETF after less than 30 days, you may be subject to the wash sale rule.

The single biggest risk in ETFs is market risk. Like a mutual fund or a closed-end fund, ETFs are only an investment vehicle—a wrapper for their underlying investment. So if you buy an S&P 500 ETF and the S&P 500 goes down 50%, nothing about how cheap, tax efficient, or transparent an ETF is will help you.

Unlike ETFs, mutual funds can offer more specific strategies as well as blends of strategies. Mutual funds offer the same type of indexed investing options as ETFs but also an array of actively and passively managed options that can be fine-tuned to cater to an investor's needs.

You expose your portfolio to much higher risk with sector ETFs, so you should use them sparingly, but investing 5% to 10% of your total portfolio assets may be appropriate. If you want to be highly conservative, don't use these at all.

ETFs have several advantages for investors considering this vehicle. The 4 most prominent advantages are trading flexibility, portfolio diversification and risk management, lower costs versus like mutual funds, and potential tax benefits.

Key Takeaways

ETFs tend to be more liquid, have lower net fees, and are more tax efficient than equivalent mutual funds. For those seeking a more active approach to indexing, such as smart-beta, a mutual fund may provide more expert professional management.

At least once a year, funds must pass on any net gains they've realized. As a fund shareholder, you could be on the hook for taxes on gains even if you haven't sold any of your shares.

With the managed fund version, you can buy as often as you like without any added cost, but to buy ETFs, you need to buy through a broker, and there is a minimum brokerage cost per purchase.