By Sarah O'Brien, CNBC
So you're getting started in the investing world and keep seeing mutual funds and exchange-traded funds as options. What's the difference, you wonder. And does it matter?
While there are similarities between the two, the differences could determine whether one or the other (or a mix) makes the most sense for you.
"It's very important to understand the differences between them," said Frank McAleer, senior vice president of wealth, retirement and portfolio solutions at Raymond James. "How you use them depends on your investing time frame, your goals, your financial plan — there are a lot of considerations."
Here's a look at the key differences between ETFs and traditional mutual funds to help you decide how either or both might fit into your investment strategy.
The basics
Both are essentially pools of money in which investors buy shares. The funds invest their assets in stocks or bonds (or both) or other types of investments (i.e., commodities such as gold or silver), depending on the fund's objective.
Many traditional mutual funds are actively managed, meaning investment experts are at the helm choosing where to invest a fund's assets.
Other mutual funds are passively managed funds. That is, their holdings mimic those of an index, such as the S&P 500, instead of having someone handpicking the investments.
On the ETF side, most are passively managed and follow an index, although a small share do employ active management.
Cost
For the most part, actively managed funds cost more than those that are passively managed because you're paying for investment-picking expertise.
In investment funds, the cost is called the expense ratio and is expressed as a percentage. It's the share of your assets that the fund takes each year from your account as compensation for managing your money.
The average expense ratio for actively managed mutual funds is 1.1 percent, according to Morningstar, an investment research and management firm in Chicago. For ETFs, meanwhile, the passive bulk of them come with an average expense ratio that's half that: 0.51 percent.
Your investment fees matter because they take a bite out of money that otherwise would be in your account to continue growing. The bigger the yearly expense, the bigger the hit to your earnings over time.
Say you invested $100,000 for 20 years and your annual return was 4 percent. If you paid 0.25 percent yearly, you'd have close to $210,000 at the end of those two decades, according to the Securities and Exchange Commission's Office of Investor Education and Advocacy.
In contrast, if you paid 1 percent a year, the return on that $100,000 after 20 years would be way less: $180,000.
The investments
As mentioned, actively managed funds have an expert — or team of experts — choosing exactly how to invest your money. The fund's prospectus outlines parameters that the fund managers must follow when choosing investments, and performance is based on whether the fund's management team gets their picks right.
Most ETFs have no flexibility in the investments, so if the index they track does well, so does your holding. And if the index tanks? Guess what.
In theory, in actively managed mutual funds, the mix of holdings can be altered by the fund manager to avoid huge losses. While that doesn't always turn out as planned, it's an advantage that could bode well in a bad market environment.
Of course if you're invested for the long haul, short-term swings in the market — or even prolonged down markets — shouldn't make you panic.
Trading
Another big difference between traditional mutual funds and ETFs is how they are traded.
Traditional mutual funds — whether actively managed or index funds — can only be bought and sold once daily, after the market's 4 p.m. ET close.
In contrast, ETFs trade throughout the day like stocks. This means investors can react to market news quickly to buy or sell when it suits them.
However, long-term investors — such as those saving for a retirement that's decades away — should generally be sticking to an investment strategy that is not based on trying to time the market, whether they are in ETFs or mutual funds.
"Most long-term investors have no real need to be able to transact at, say, 10 in the morning instead of at the end of the day," said Ben Johnson, director of global ETF research at Morningstar.
Tax treatment
When mutual funds sell investments throughout the year, any profits from those transactions get passed on to the fund's shareholders via capital gains distributions.
If your mutual funds are in a taxable account — i.e., a brokerage account — you'll owe taxes on the gains for the year they were distributed.
However, if you hold mutual funds in a tax-advantaged account — i.e., 401(k) plan or an individual retirement account — you don't need to worry about it because gains are deferred until you withdraw money in retirement.
"If you're a long-term investor, it's not a big deal," McAleer said. "It's the short-term investor's dilemma."
Generally speaking, capital gains are less likely with ETFs, due to how they are constructed and how they are traded. This makes them generally more tax-efficient.
Transparency
Most mutual funds disclose their holdings quarterly. In contrast, investors can view a typical ETF's holdings online any time they want.
However, some experts think this difference matters little to most investors.
"I'd argue there are very few investors who care to look at all stocks that their ETF owns every day," Johnson said.
