Exchange-traded funds, or ETFs, and mutual funds are often used interchangeably because they share so many similarities and can accomplish the same crucial investment goal: diversifying your portfolio.
Both enable investors to purchase a basket of assets, usually a mix of stocks and bonds, that were selected by teams of expert investors. But there are significant differences between ETFs and mutual funds.
For starters, during regular trading hours for U.S.-based stock exchanges, you can purchase any ETF for whatever price it's trading at, just like with stocks. But with mutual funds, you have to wait until markets are closed to buy or sell them because that's when their net asset value, a metric that represents the commutative value of all the assets in the fund, is calculated.
Here are some other key differences.
Consider the following hypothetical example:
There's a supermarket delivery service that offers customers two different weekly subscription options. Under the first option, your weekly order will be based on what the typical American household buys, which rarely changes over time. You can't make substitutions or remove any goods that you don't want. Total cost: $90 a week. And there is no minimum weekly subscription.
Under the second option, you can select a category that best suits your dietary needs. So if you're vegan you don't have to worry about getting stuck with chicken breast. And as new products are introduced or certain items go on sale, the person who oversees shopping lists will make adjustments. Total cost: $175 a week, and you must commit to at least an eight-week subscription.
The first option in a very basic sense is akin to an ETF. ETFs typically are built based on what's included in a major index like the S&P 500 or a subindex like S&P 500 consumer staples. Because they track indexes, the composition of ETFs typically change only when indexes do, which isn't often.
On average, index-tracking ETF fees shake out to 0.18% of your investment annually, according to a 2021 report published by the Investment Company Institute, (ICI), an investment industry association. So if you put in $1,000, you'd pay $18 in fees.
That's significantly smaller than the 0.50% fee on average for investing in an equity mutual fund. In that case, if you invested $1,000, you'd pay $50 in fees. Mutual funds, if you haven't already guessed, are similar in a basic sense to the second option in the shopping example.
In both cases, you're required to pay the fees regardless of how the fund or ETF performs.
So what justifies the higher fees for mutual funds?
Level of customer service
Mutual funds tend to have higher fees than ETFs because they are often actively managed by a fund manager. This means that a team of investment experts keep close tabs on the fund's performance and trade securities based on what they believe will generate the best return for investors.
In addition to annual fees, many actively managed mutual funds require investors to make a minimum investment. For instance, Vanguard has a $3,000 minimum requirement.
There are many exceptions, because there's a wide variety of mutual funds. Index funds, a type of mutual fund that tracks a major stock index, don't have fund managers actively making investment decisions. As a result, fees for index funds are even smaller than ETFs, 0.06% on average, according to ICI.
Which has better returns?
Take a look at the five-year performance of the oldest and one of the most popular ETFs, SPDR S&P 500 ETF Trust, traded under the ticker SPY. As you can see below it had nearly identical returns compared with the S&P 500.
The reason it doesn't have the same return as the S&P 500 is a result of slightly different sector allocations. For instance, 26.93% of the SPY comprises information technology assets compared with 26.92% for the S&P 500. The expense ratio for SPY is 0.0945%.
Now take a look at one of the most popular actively managed mutual funds, American Funds Washington Mutual Investors Fund Class 529-A, traded under AWSHX. Even with its 0.56% expense ratio, it still underperformed the S&P 500 and SPY ETF over the past five years. But over the past year, it outperformed the two.
As you can tell from the chart, this fund has a very different asset allocation from SPY.
The returns on SPY versus AWSHX aren't indicative of how all ETFs and mutual funds perform since the asset allocation for them varies.
How to pick which is right for you
The decision mainly boils down to cost and control.
ETFs typically charge lower fees and have smaller minimum investments than mutual funds. Additionally, because of the way mutual funds are structured, they tend to generate higher taxes than ETFs while you hold them.
With mutual funds, you forfeit a degree of control in terms of when you can buy or sell them and at what price. But you get the benefit of having a team of experts to make some of those decisions.
Elisabeth Buchwald is a personal finance and markets correspondent for USA TODAY. You can follow her on Twitter @BuchElisabeth and sign up for our Daily Money newsletter here
This article originally appeared on USA TODAY: Are EFTs better than mutual funds? Breaking down the differences