What Are the Differences Between Mutual Funds and ETFs?

Mutual funds and Exchange Traded Funds are two of the most common investment products that investors use to seek growth.  Their names are often confused because they are similar in nature, but have distinct differences that a potential investor must know before purchasing one or the other.  

Mutual Fund

A mutual fund is a virtual investment company that pools money from many investors and invests it based on specific investment goals.  The mutual fund is operated by a fund manager that is appointed by the mutual funds board of directors. The fund manager is obligated to work in the best interest of mutual fund shareholders.  Most, but not all fund managers are also owners of the fund.

Mutual funds raise money by selling shares of the fund to potential investors.  The money raised is used to purchase a portfolio of stocks, bonds, short-term money-market instruments, other securities or some combination of these investments.  Each mutual fund has a specific investment strategy which is achieved by purchasing certain investments that fit the fund’s objectives.

There are thousands of individual mutual funds but there are only a handful of mutual fund categories.  These categories consist of (1) stock funds, (2) bond funds, (3) Balanced funds, a general mix of stocks and bonds, (4) Money Market Funds, which invest in very short-term investments and are sometimes described as cash equivalents, (5) Funds of Funds, which invest in other mutual funds, and (6) target-date Funds, which are funds of funds that change their investment mix over time.  

A potential investor has to purchase shares directly from the mutual fund.  One cannot purchase shares of a mutual fund on the stock market like one would buy Apple stock.  Instead, investors use a broker to purchase and redeem shares of a specific mutual fund.

Exchange Traded Funds (ETFs)

An exchange traded fund is a pool of stocks, bonds, and other assets.  ETFs can offer investors the opportunity to invest in a professionally managed, diversified portfolio of investments.  The key difference between mutual funds and ETFs is that mutual funds are purchased once a day while ETFs can be purchased all day and its price fluctuates according to market influences.  Investors do not purchase and redeem shares directly from the ETF like a mutual fund. Rather, an investor must purchase them on a public exchange. Investors can then buy or sell ETFs on public exchanges throughout the trading day just like stocks through a brokerage account.

The key difference between mutual funds and ETFs is that mutual funds are purchased once a day while ETFs can be purchased all day and its price fluctuates according to market influences.

Most ETFs track a specific market index such as the S&P 500.  These ETFs are therefore somewhat similar to mutual funds in the sense they track performance of a specific market benchmark or other index.  Some of the most actively traded ETFs track the most familiar market benchmarks like the SPDR S&P 500 and the SPDR Dow Jones Industrial Average ETF. ETFs are typically created to match the performance of the index, not surpass it.

Both ETFs and mutual funds calculate the net asset value (NAV) of their portfolios at the end of each trading day.  There are some differences between how they calculate this figure, but generally the NAV comes from calculating the total value of all the securities in the fund.  The NAV is the price at which the mutual fund investor will buy or sell their shares. ETF investors, however, will pay market value for their shares, which may or may not equal the NAV at any given time since the market value of the shares will fluctuate throughout the trading day.