ETF vs. Stock vs. Mutual Fund: What Are the Differences?

Exchange-traded funds (ETFs) combine features of both stocks and mutual funds, trading on exchanges throughout the day while offering diversification across multiple securities. Individual stocks, meanwhile, represent ownership in a single company, potentially offering higher returns but with increased risk. Mutual funds pool money from multiple investors to purchase a portfolio of securities, typically managed by professionals and priced once daily after market close. Each investment type comes with its fee structure, minimum investment requirements and tax implications. A financial advisor can help you determine which asset makes more sense for your portfolio.

How ETFs Work

ETFs operate similarly to stocks in that they trade on exchanges throughout the day at market-determined prices. Unlike mutual funds, which are priced once daily after market close, ETFs allow investors to buy and sell shares whenever the market is open. This provides greater flexibility for those who want to react quickly to market movements or implement specific trading strategies.

Most ETFs are designed to track the performance of a specific index, sector, commodity or asset class. The fund manager builds a portfolio that mirrors the composition of the target index, whether it’s the S&P 500, a bond index or a specialized sector index. This passive management approach typically results in lower operating expenses when compared with actively managed funds.

Pros of Investing in ETFs

Diversification at low cost: ETFs allow investors to gain exposure to a wide range of securities in a single transaction. By holding a basket of assets, ETFs help spread risk across multiple companies or sectors, reducing the impact of poor performance from any single investment.
Tax efficiency: ETFs typically generate fewer capital gains distributions than mutual funds. When investors sell ETF shares, they’re typically selling to other investors rather than requiring the fund to sell underlying assets. This results in fewer taxable events.
Specialized market access: ETFs provide easy access to specialized markets, sectors or investment strategies that might otherwise be difficult for individual investors to tap into. From commodities to foreign markets to specific industries, ETFs offer diverse investment opportunities with minimal effort.

Cons of Investing in ETFs

Limited dividend options: Unlike some mutual funds that offer automatic dividend reinvestment plans, many ETFs distribute dividends as cash. Investors must then manually reinvest these dividends, potentially leaving cash uninvested for periods and missing out on compound growth opportunities.
Liquidity concerns with specialized ETFs: While popular ETFs trade with tight bid-ask spreads, niche or specialized ETFs may have lower trading volumes. This reduced liquidity can result in wider spreads and potentially higher costs when buying or selling shares, particularly during market volatility.

How Stocks Work

When you buy a stock, you’re purchasing a small piece of ownership in a single company. This ownership stake, also known as equity, represents a claim on the company’s assets and earnings. As a shareholder, you become a partial owner of the business. You’ll have rights that may include voting on corporate matters and receiving dividends if the company distributes profits.

Companies issue stocks to raise capital for business operations, expansion, or debt reduction. Initially, stocks are offered through an initial public offering (IPO). Afterward, they trade on secondary markets like the New York Stock Exchange or NASDAQ. These exchanges function as marketplaces where investors can buy stocks from or sell to other investors, with prices fluctuating based on supply and demand.

Pros of Investing in Stocks

Potential for high returns: Stocks have historically outperformed other investment vehicles over long time horizons. Compared to ETF and mutual fund performance, individual stocks offer the possibility of substantial growth, especially if you invest in companies that experience significant expansion.
Liquidity and flexibility: Most stocks can be bought or sold during market hours with minimal delay. This liquidity allows investors to quickly convert their investments to cash when needed or make rapid adjustments to their portfolio strategy.
No management fees: Unlike mutual funds and some ETFs, direct stock ownership doesn’t involve ongoing management fees that can erode returns over time. You’ll typically only pay transaction costs when buying or selling shares.

Cons of Investing in Stocks

Higher volatility: Individual stocks typically experience more dramatic price swings than diversified investments like ETFs or mutual funds. This volatility can be emotionally challenging for investors, potentially leading to panic selling during market downturns or overconfidence during bull markets.
Higher trading costs: Buying individual stocks often involves more frequent trading and potentially higher commission costs compared to purchasing ETFs or mutual funds. These transaction costs can erode returns, especially for investors with smaller portfolios.

How Mutual Funds Work

A couple reviewing the performance of their mutual funds.

Mutual funds operate as pooled investment vehicles. Money from many investors is collected and used to purchase a diversified portfolio of stocks, bonds or other securities. When you invest in a mutual fund, you’re essentially buying shares of the fund itself, not the individual securities it holds. This allows everyday investors to gain exposure to potentially hundreds of different securities with a small investment, making diversification more accessible.

Mutual funds come in various types to meet different investment objectives. Equity funds invest primarily in stocks, while bond funds focus on fixed-income securities. Balanced funds maintain a mix of both stocks and bonds. Index funds passively track market benchmarks, while actively managed funds aim to outperform the market.

Pros of Investing in Mutual Funds

Professional management: Mutual funds are managed by financial professionals who make investment decisions on behalf of shareholders. These fund managers conduct extensive research, analyze market trends, and adjust portfolios strategically, offering expertise that individual investors might not possess.
Liquidity: Mutual funds can typically be bought or sold on any business day at the net asset value (NAV) price calculated at the end of the trading day. This lets investors convert their investments to cash relatively quickly, though not with the same intraday trading flexibility as stocks or ETFs.
Accessibility: Mutual funds offer a low barrier to entry for beginning investors. Many funds allow initial investments as low as $500−$1,000, with subsequent contributions of even smaller amounts. This makes them an accessible option for those just starting their investment journey.

Cons of Investing in Mutual Funds

Potential tax inefficiency: Compared to ETFs and stocks, mutual funds often come with less favorable tax treatment. Fund managers’ buying and selling activities can generate capital gains distributions that are passed on to all shareholders. You may have tax liabilities even if you haven’t sold your shares.
Higher fees and expenses: Mutual funds typically charge higher expense ratios when compared with ETFs and individual stocks. These management fees often range from 0.5% to 1.5% annually. Fees can significantly erode your returns over time, especially in funds with active management strategies.

How to Decide What to Invest in

Each investment vehicle offers different benefits. ETFs provide simplicity and diversification with lower expense ratios and trading flexibility. Individual stocks offer potential for higher returns but are less convenient and come with increased risk. Mutual funds are convenient and offer professional management but may have higher fees.

When determining what to invest in, start by clarifying your financial objectives. Are you saving for retirement, a home purchase, or your child’s education? Your goals will influence your investment timeline and risk tolerance. Short-term goals might require more conservative investments, while long-term objectives allow for potentially higher-return strategies that can weather market fluctuations.

It might be best to discuss your investment options with a professional advisor to help you fully understand the right mix of investments for your portfolio.

Bottom Line

Diversifying your investments can offer you greater flexibility.

The right choice for your portfolio ultimately depends on your personal financial goals, risk tolerance and investment timeline. New investors might appreciate the simplicity and built-in diversification of ETFs or mutual funds. Experienced investors may prefer the control and potential returns of individual stocks. Many successful portfolios incorporate a strategic mix of these investment vehicles to balance growth potential with risk management. Whatever your choice, consistent investing with a long-term perspective remains one of the most reliable paths to building wealth.

Investment Planning Tips

A financial advisor can help manage your portfolio. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Asset allocation is a prime concern for investment and portfolio construction. SmartAsset’s asset allocation calculator can help you select an asset mix that fits your personal risk tolerance and investment style.