By David Koch, CFP®, AIF®, CFA, Director of Portfolio Management/Senior Wealth Advisor
A Quick Primer for Understanding Common Investment Options
You’re probably familiar with the terms ETF and mutual fund, but what exactly are these financial vehicles, and how do they differ from each other? Whether you’re a beginner hoping to start your investment journey or a curious mind eager for clarity, this article breaks down the key differences and hopefully throw in a few fun tidbits along the way to make you sound smart at your next BBQ.
Let’s Begin – What Is a Mutual Fund?
Like an ETF, a mutual fund is a basket of investments inside of it, called underlying investments. Instead of trading like a stock on an exchange with other investors (like an ETF does), mutual funds are generally bought and sold directly through the fund company at a price calculated at the end of the trading day (called the net asset value, or NAV).
The first fund-like structure was likely started in 1774 in the Netherlands with an investment trust called Eendragt Maakt Magt (“Unity Creates Strength”). The idea spread across Europe, with investment trusts forming in Switzerland (1849) and Scotland (1880s) and in the U.S., the Boston Personal Property Trust (1893) and the Alexander Fund (1907) were early examples of these similarly pooled investment vehicles. These were private funds, more like limited partnerships.
The first modern mutual fund in the United States, as we know them today, was the Massachusetts Investors Trust, launched on March 21, 1924. This fund is notable for being the first open-end mutual fund, meaning it allowed continuous issuance and redemption of shares between investors and the managers of the fund.
Mutual funds were a huge benefit to investors because they allowed them to make one investment which gave them a more-or-less diversified portfolio, instead of doing each trade manually. Back when stock trades were more expensive, this was a significant benefit; so was the professional management of what investments to make.
What Is an ETF?
ETF stands for “Exchange-Traded Fund.” Think of an ETF as a basket filled with a variety of investments like stocks, bonds, or commodities that can be traded on an exchange among other investors, just like a regular stock. Early ETFs were designed to track the performance of a particular index, for example, SPY was the first ETF (which tracks the S&P 500), and by buying one share of SPY, you’re investing in a basket of 500 major U.S. companies.
Because most early ETFs were passive index funds, this perception still exists, however, many exotic ETFs have hit the marketplace in the last decade including commodity-linked ETFs, volatility-linked ETFs, and 2x and 3x leveraged ETFs. Many investment strategies that only existed in the hedge fund space 20 years ago are available in ETF form now, for better or worse.
Fun fact: the SPY exchange-traded fund launched in 1993 but its organizers had to work around a New York trust law that prohibits assets from being locked away in perpetuity, so a solution was to set up SPY to terminate 20 years after the death of the last survivor of 11 selected “measuring lives,” or in 2118, whichever comes first. Called the “SPY Kids,” or the “SPY 11,” the 11 individuals selected were mostly relatives of the team that created SPY who were born between May 1990 and January 1993. What makes this interesting is that the SPY ETF holds almost $660 billion (as of September 2025) and the whole vehicle is set to be distributed 20 years after the death of the last one to pass away.
Key Differences: ETF vs. Mutual Fund
Fees and Expenses
ETFs are generally known for having lower expense ratios compared to mutual funds, but as I mentioned, this is not always the case. As of this writing (unless my database is hallucinating), I have found several with expense ratios greater than 10% per year.
This gets a little into the weeds, but I think it is worth mentioning. Since mutual funds are traded once per day, every investor gets the same price who bought or sold on that given day. This is an advantage, but mutual funds often have different share classes which can pay brokers a commission.
There can be a commission when you buy the fund, called a front-end load (often the A share class). There can be a commission when you sell, called a back-end load (often the B share class), or a higher expense ratio which pays the broker a commission for as long as you hold the fund, called a level-load (often the C share class). There are often institutional share classes that don’t pay commissions, but these tend to have very high minimums (like $1 million or more) and are often out of reach for most investors.
One way to help avoid these fees is to work with a “fee-only” advisor who often will have access to the institutional share class because they meet those minimums at the firm level. Note: the “fee-only” term is very confusingly like “fee-based,” which designates an advisor that may be billing a quarterly/annual management fee AND collecting a commission on the share class they invest you in.
Discounts and Premiums of ETFs
ETFs can be bought and sold throughout the trading day, just like a stock. Mutual funds, on the other hand, can only be bought or sold at the end of the day. During trading, if you’re looking at the price of a mutual fund, you’re seeing yesterday’s price, but if you look at the price of an ETF it will reflect the movement of the market in real time. Like I said before, mutual funds always trade at the net asset value (NAV), which is the value of all the underlying investments added together divided by the number of fund shares.
Because ETFs are traded throughout the day, on the other hand, they may trade at prices above or below the value of what they actually own. This is called the premium when the ETF price is more than the basket of its investments are worth, and a discount when it is trading below.
While these premiums and discounts don’t tend to perpetuate because the authorized participants can arbitrate them away (more on that later), these can temporarily cause price dislocations. An ETF trading at a 5% premium means that investors are paying $105 for $100 worth of underlying investments; or they’re paying $95 for $100 if the ETF is trading at a 5% discount. From my experience, most investors don’t pay attention to ETF premiums and discounts.
Spreads of ETFs
ETFs on the other hand don’t tend to have broker commissions, but that’s not to say there are no additional costs to investing in them beyond their expense ratio. While mutual funds all trade at the same price, not only does the price of an ETF fluctuate throughout the day, but ETFs also trade at a spread. Called the bid-ask spread, this is the price difference between when someone pays for a share to buy the ETF vs what someone receives when they sell it.
Big, liquid ETFs that trade in high volumes have very small spreads. The spread on SPY, for example, is often a penny. With an average daily trading volume of nearly 70 million shares, that starts to add up to real money. On the other hand, a smaller, more thinly traded ETF might have a spread of $0.50 or more. That is a cost to the investor that they will never see a line item for.
The people who earn the spread are called market makers, and a large ETF like SPY might have dozens of market makers aiming to facilitate efficient trade execution. Smaller ETFs may only have one or two.
Tax Efficiency of ETFs
There is one more major difference between mutual funds and ETFs that we should discuss, the authorized participant (AP). The AP creates and redeems shares in the ETF by buying and selling the underlying investments that the ETF holds (like the shares in all 500 companies in the S&P 500 in the case of SPY) and then delivering it to the ETF issuer “in-kind”. (I’m not going to go down the rabbit hole here, if you want to on your own, search up “heartbeat trade” and say hi to the Mad Hatter down there for me.)
What investors should know about this process is that this allows ETFs to exchange the underlying investments with the AP without selling them, and ultimately not realizing capital gains. It isn’t perfect, but the benefit to ETF shareholders is that they are less likely to have a capital gain distribution that they would have with an otherwise identical mutual fund, thus making ETFs more tax efficient.
Caveat Emptor
Since the early ETFs were passive index funds, I still think that view of them permeates. There are now ETFs for virtually everything, however, from traditional stocks and bonds to themes like clean energy, artificial intelligence, options, 3x leveraged single-stock ETFs, and even pet care.
Many of these esoteric and sometimes bizarre ETFs have high expense ratios and low liquidity (wide bid-ask spreads). They may be more volatile and/or less diversified than traditional index ETFs, and some are leveraged or inverse (go against the market), which can amplify risk.
The most infamous ETF debacle, in my opinion, was a short-volatility ETF called XIV (like VIX, but backwards!). It was essentially short the VIX volatility index (profiting when the VIX stayed low) and imploded when the VIX index spiked from 17 to 37 in February 2018. XIV lost almost $2 billion in shareholder wealth in just a matter of days during a period of market turmoil dubbed Volmageddon.
I truly feel awful for those investors who lost a meaningful amount of wealth in the process, but to investment professionals a short volatility trade is a strategy often called “picking up nickels in front of a steam roller” – or in this case, being a perfectly fat and happy turkey in early November.
Sources:
A Brief History of the Mutual Fund
The History of Mutual Funds and Their Evolution Over Time – Accounting Insights
Meet The ‘SPY 11’ Kids With $250 Billion Riding On Their Lives
ETF Fees and Associated Costs of ETF Investing | Charles Schwab
Authorized Participants and ETFs: Tax Efficiency: A Win Win for Investors – FasterCapital
ETF premiums and discounts, explained | Vanguard
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