Mutual funds or ETFs: How do I choose?

Both can play a valuable role in helping you pursue your financial goals. Consider these common investing scenarios to see whether one — or both — is right for you.
Both mutual funds and exchange-traded funds (ETFs) share features that can serve investors well. Each delivers diversification by bringing together dozens — sometimes hundreds or even thousands — of individual stocks or bonds (or both) into a single offering.Footnote 1
But there are some significant differences between them. "Understanding those differences can be the key to building a portfolio that helps you meet your goals," notes Raj Kohli, head of Portfolio Research and Analysis, Chief Investment Office, Merrill and Bank of America Private Bank. "The right approach for you may be a combination of the two.
Mutual funds might make more sense in certain situations, while an ETF might be a better pick in others. The right approach for you may be a combination.
— Raj Kohli,
head of Portfolio Research and Analysis,
Chief Investment Office,
Merrill and Bank of America Private Bank

Making the choice

One important characteristic of mutual funds and ETFs is the way they're managed. While mutual funds can be either actively or passively managed, most ETFs are passively managed. What do these terms mean?
  • Actively managed fund: With this fund category, a portfolio manager chooses which individual securities to buy with the aim of getting the highest possible return. Such a fund can perform better or worse than the market overall.
  • Passively managed fund: This type of fund aims to mimic the performance of a specific market benchmark or index — such as the S&P 500 — by holding only securities in that index. A passively managed fund is unlikely to perform significantly better or worse than the benchmark it follows.
For more insights on how mutual funds and ETFs differ, take a look at four common investing scenarios — chances are you'll fit into one or more of them.
Sector investing
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Sector investing
You're interested in investing in a specific industry or sector
Sector investing
Behind the choice: Both mutual funds and ETFs allow you to target specific market sectors, such as healthcare or real estate, or individual countries or regions, but the level of specificity differs.
What to consider: ETFs tend to offer more targeted choices — in a category like healthcare, for instance, you can find ETFs focused on market niches such as medical devices or biotech. Mutual funds may not offer as many ways to narrowly focus on a specific sector. Still, an actively managed mutual fund can have its advantages. "Professional portfolio managers tend to specialize in certain sectors, and you might benefit from their knowledge," suggests Christopher Vale, senior vice president, Preferred Client Experience, Bank of America.
Investing over time
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Investing over time
You plan to make regular, periodic contributions to your account
Investing over time
Behind the choice: When you save small amounts on an ongoing basis versus simply investing a lump sum, transaction fees and minimum investments can vary widely.
What to consider: Many mutual funds don't assess sales or transaction fees when you buy or sell shares. Some require a minimum investment to open your account but allow for subsequent smaller investments. Others charge no sales fee if you set up regular automatic investments.
By comparison, ETF shares are bought and sold like individual stocks, so you can buy a single share, but any transaction may involve a fee. "As a result, if you make ongoing modest-sized investments — say biweekly or monthly — any fees can add up and eat into potential gains," Vale says. That makes mutual funds potentially more appropriate for investors who want to invest small amounts over time.
Short-term trading
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Short-term trading
You want the flexibility to react to market moves when they occur
Short-term trading
Behind the choice: Some investors enjoy monitoring the market to try to capitalize on short-term shifts, while others pay less attention to daily swings sparked by the news.
What to consider: While markets are open, the share price of an ETF rises and falls — much as a stock does — based on the changing value of its underlying securities. That makes it easier for active traders to take advantage of short-term movement in the markets. On the other hand, a mutual fund's share price is generally set once a day, based on the price of its securities at the market's closing bell, making it less appropriate for capturing short-term market movements.
Active management
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Active management
You want active management of your investments
Active management
Behind the choice: Actively managed mutual funds can make sense in certain situations. In heavily traded markets, like U.S. large-cap stocks, most, if not all, of the information about a company is already known, so it can be difficult for a money manager to outperform the market. In more thinly traded markets — Vale cites high-yield fixed income and small-cap and emerging market stocks as examples — "the specialized knowledge of a professional money manager could add real value," Vale says. Just bear in mind that a money manager's expertise can mean higher expenses, which will lower your returns.
What to consider: If you're seeking to earn a return that matches a market index (or comes close), buying a passively managed fund can be a lower cost option. You can get access to a wide variety of investments that track indexes with either a mutual fund or an ETF. Even though actively managed ETFs are becoming increasingly available, most are passively managed.

The bottom line

Both mutual funds and ETFs serve a purpose — whether one is "better" than another is entirely a matter of your circumstances, objectives and investing preferences. A firm grasp of your goals is the essential starting point, Kohli points out, but it's also critical to understand how much risk you're willing to take on as well as your time frame for reaching your goals. "Armed with that information," he says, "you're in a much better position to decide on the approach that may be appropriate for you."

Next steps

Footnote 1 Diversification does not ensure a profit or protect against loss in declining markets.

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