Mutual funds vs. ETFs: How do these types of investment funds stack up?

Investing can offer you a path to growing wealth steadily over time, helping you reach goals you've envisioned for your family and your retirement years. But it does come with its share of risks. Building a diversified portfolio can help to hedge those risks, spreading your assets across different types of funds.

Open-end mutual funds and exchange-traded funds (ETFs) are two types of fund categories that give you access to a basket of stocks, bonds and other assets. They share some characteristics, and you even may consider investing in both. Let's break down mutual funds vs. ETFs to see how they might fit in your financial strategy.

In a mutual fund, professional money managers choose and manage a collection of stocks and bonds you can invest in. They base this collection on fund objectives and seek to outperform the fund's benchmark index and its peer group. This type of investing lets you pool your money with other investors to gain exposure to securities that may be hard to invest in otherwise.

• Most mutual funds are actively managed. A smaller percentage of mutual funds passively track the performance of individual market indexes, like the S&P 500.
• You buy and sell shares at a set price at the end of the trading day through either the company that created the fund or a brokerage.
• The price of a mutual fund is based on the fund's net asset value (NAV), or the total market value of all the assets contained in the fund. If it holds $10 million of stocks and has 1 million shares, each share is worth $10. When you buy or redeem shares during the day, you won't know what the price is until the next NAV is calculated.

While a common mistake to make, an ETF is not a type of mutual fund. Though they are pooled investment funds with a mix of securities managed by professional money managers, ETFs share more characteristics with conventional stocks.

• Most ETFs are passively managed and simply aim to mirror the return of indexes. The percentage of actively managed ETFs is small but on the rise.
• You buy and sell shares through a brokerage account at fluctuating market prices.
• The price you pay to buy or sell ETF shares may not match the value of the ETF's underlying holdings. The ETF can be priced above its NAV (at a premium) or below its NAV (at a discount) due to factors like investor demand for the fund.

You have preferences as an investor. When deciding which of these funds may be a better fit for your plan, factor in the importance of fees, taxes, transparency and how you like to handle dividends and capital gains distributions.

Because most ETFs are passively managed, these kinds of funds are less costly to operate. As a result, they generally have lower operating and administrative fees known as expense ratios. Actively managed funds, meanwhile, have historically been more expensive to run, resulting in higher expense ratios.

In addition, some share classes of mutual funds have sales charges called "loads." ETFs don't have loads. Before investing in a mutual fund or ETF, be sure to research its expense ratio as well as potential brokerage commissions and other transaction costs.

Both types of funds earn a capital gain, which may be taxable, every time they sell securities that increased in price. Because funds that track indexes generally buy and sell securities much less frequently than actively managed funds, they generate fewer capital gains distributions to shareholders.

In addition, ETFs are built in a way that minimizes capital gains distributions. Generally speaking, ETFs have the ability to meet redemptions in-kind, rather than by selling the portfolio securities. The SEC notes that "index-based ETFs' costs and taxes can be even lower than index mutual funds' because of the manner in which ETFs operate."

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How do index funds work?

Many mutual funds & exchange-traded funds (ETFs) track the performance of specific market indexes, but these indexes can come with advantages and disadvantages. 

Dive deeper

Many mutual funds require you to invest a flat dollar amount. Some companies will reduce the minimum if you sign up for an automatic purchase plan.

ETFs don't come with investment minimums. You can buy an ETF for the price of a single share. Alternatively, if you prefer to invest a certain dollar amount, you may be able to buy a fractional share of an ETF.

If you only seek to put your money in sectors or companies that align with your values, you need to know what mutual funds or ETFs are holding before you add them to your portfolio. Some ETFs tell the public which assets they hold each day, but you'll need to wait longer for most mutual funds. They generally disclose their holdings on a monthly or quarterly basis.

If a mutual fund pays dividends or capital gains, you easily can arrange for both to be reinvested into your account, which increases the number of shares you own. The process can be complicated with ETFs and can incur more brokerage fees.

The answer lies with you and your needs—although owning both kinds of funds be an effective strategy for diversifying your portfolio. If you have a 401(k), you probably already own some mutual funds, as ETFs aren't as common in employer-sponsored plans today.

ETFs may be a good match if you're comfortable with exchange-traded investments, you prioritize tax efficiency in your taxable accounts, and you want to own funds with low fees and no initial minimums.

Mutual funds may be right for you if trading in the market isn't your cup of tea, you're seeking a wider breadth of actively managed options, and you prefer to reinvest your dividends and capital gains distributions.

Get in touch with a local Thrivent financial advisor to learn how you can leverage ETFs and mutual funds to reach your investment goals.