ETFs vs Mutual Funds: How They Differ

ETFs and mutual funds are both pooled funds: many investors put money into one portfolio managed under a single set of rules. The main difference is how you buy and sell them. A mutual fund is bought from and sold back to the fund company at one price set once a day, while an ETF trades on a stock exchange all day at whatever price buyers and sellers agree on.

In short: the portfolio inside can be identical. What differs is the wrapper: how orders are priced, who you trade with, how costs are charged, and (in the US especially) how often the fund passes taxable gains to you. Neither wrapper is automatically cheaper or better. A high-fee ETF exists, and so does a low-fee index mutual fund.

How a mutual fund works

When you buy a mutual fund, you send money to the fund (usually through a dealer, advisor, or brokerage). The fund issues new units to you. When you sell, the fund cancels your units and pays you cash, selling holdings if it needs to.

One price a day

Every business day, after the market closes, the fund calculates its net asset value (NAV) per unit:

NAV per unit = (value of all holdings + cash - liabilities) ÷ units outstanding

In the US, SEC rules require forward pricing: an order placed during the day is filled at the next NAV calculated, usually after the 4:00 p.m. Eastern close. Canadian mutual funds work the same way. You do not know your exact price when you place the order, and every investor who buys or sells that day gets the same price.

How an ETF works

An ETF’s units are listed on an exchange such as the NYSE, Nasdaq, or TSX. You buy them through a brokerage account from another investor, exactly as you would buy a share of a company (see how to buy a stock). The price moves throughout the trading day, and you can use limit orders and other order types.

Creation and redemption

If ETF units just traded between investors, what keeps the market price close to the value of the holdings? A mechanism called creation and redemption.

The ETF signs agreements with a small number of large financial firms called authorized participants (APs). In the SEC’s investor bulletin on ETFs, the description is roughly this:

Creation. An AP delivers a basket of the fund’s underlying securities (and sometimes cash) to the ETF and receives a large block of new ETF units, called a creation unit. The SEC uses 50,000 units as an example of block size. The AP can then sell those units on the exchange.
Redemption. The reverse. An AP hands a block of ETF units back to the fund and receives the underlying basket.

This lets APs and market makers profit from gaps between price and value. If the ETF trades above the value of its holdings, an AP can buy the cheaper underlying stocks, exchange them for new ETF units, and sell those units at the higher price. That selling pushes the ETF price down. If the ETF trades below its holdings’ value, the AP buys ETF units cheaply and redeems them for the more valuable basket. That buying pushes the price up.

A worked example

An ETF’s holdings are worth $50.00 per unit (its intraday indicative value). The ETF is trading at $50.20, a 0.4% premium. An AP buys the underlying basket for the equivalent of $50.00 a unit, delivers it to the fund for 50,000 new units, and sells them at $50.20. Gross profit: $0.20 × 50,000 = $10,000, before trading costs and fees. Many firms chasing that same gap is what keeps premiums on large, liquid ETFs to a few cents. On ETFs that hold hard-to-trade assets, the gap can be wider and last longer.

Side by side

	Mutual fund	ETF
Where you buy	From the fund company, through a dealer or broker	On a stock exchange, through a brokerage account
Price	One NAV per day, after the close	Market price, changes all day
Order types	Dollar amount, filled at next NAV	Market, limit, stop, and others
Minimums	Often a minimum initial purchase	Usually one unit, or fractions at some brokers
Trading costs	Usually none at purchase for no-load funds; may have loads or short-term trading fees	Brokerage commission (often zero now) plus the bid-ask spread
Automatic investing	Easy: fixed dollar amounts on a schedule	Possible at some brokers, sometimes with fractional units
Holdings disclosure	Periodic (quarterly in the US)	Many ETFs publish holdings daily

Tax efficiency

In the United States

Under US tax law, when a fund sells securities at a gain, it generally has to distribute that gain to shareholders, who owe tax even if they did not sell anything. A mutual fund facing heavy redemptions may have to sell stocks for cash, realizing gains that get passed on to the investors who stayed.

ETFs can often avoid this. As the SEC’s investor bulletin explains, because ETF units are usually redeemed in kind, the fund can hand the AP actual securities instead of selling them. Funds can choose to hand over the shares with the lowest cost basis, pushing unrealized gains out of the fund without a taxable sale. That is why many US equity ETFs distribute few or no capital gains in a typical year. This matters only in a taxable account. Inside a 401(k) or IRA, distributions are not taxed annually anyway (see US retirement accounts explained).

In Canada

The in-kind advantage described above comes from US tax rules. Canadian ETFs and Canadian mutual fund trusts are taxed under Canadian rules, so do not assume the US result carries over. Some Canadian ETFs distribute capital gains, and some Canadian mutual funds distribute very little. The practical approach is to check a fund’s distribution history in its annual report or fund documents. Inside an RRSP or TFSA, annual distributions are not taxed in the year they are paid.

Costs in Canada: MERs, series, and trailers

Canadian funds report their ongoing cost as a management expense ratio (MER): the management fee plus operating expenses and taxes, as a percentage of average assets. Trading costs inside the fund are reported separately as the trading expense ratio (TER). Mutual funds summarize these in a document called Fund Facts, and ETFs in ETF Facts, both required by Canadian securities regulators.

The big structural difference in Canada has been how advice is paid for. Many mutual funds sold through advisors are offered in several series (sometimes called classes). A typical advisor-sold series has a trailing commission built into its MER: part of the management fee that the fund company passes to the dealer each year for as long as you hold the fund. In Consultation Paper 81-408 (2017), the Canadian Securities Administrators (CSA) said about 1% a year was the typical trailer on actively managed equity funds. Fee-based series (often labelled F) leave out the trailer, because you pay the advisor separately.

Two CSA rule changes took effect on June 1, 2022:

The deferred sales charge (DSC) ban. Funds can no longer be sold with a DSC, a redemption fee that shrinks the longer you hold the fund. DSC schedules on purchases made before the ban were allowed to run their course.
The order-execution-only trailer ban. Fund companies can no longer pay trailing commissions to discount brokers and other dealers that do not assess whether an investment is suitable for you. If you buy a mutual fund through a self-directed account, you should not be paying for advice you are not receiving.

ETFs generally do not pay trailing commissions, which is one reason their MERs tend to be lower. But some mutual funds, especially index mutual funds and F-series units, have MERs comparable to ETFs.

A cost comparison

Suppose you invest $10,000 for one year. Option A is an advisor-sold mutual fund series with a 2.00% MER that includes a 1% trailer. Option B is an ETF with a 0.20% MER, bought with a $9.95 commission, where the bid-ask spread costs you about 0.05% on the way in. These rates are illustrative.

	Mutual fund series	ETF
Ongoing fee (on about $10,000)	$200.00	$20.00
Commission	$0.00	$9.95
Spread	$0.00	about $5.00
Year-one cost	$200.00	about $34.95

Part of the $200 pays for advice, which may or may not be worth it to you. The point is to know what you are paying and for what. The long-run arithmetic is in how investment fees work.

What can go wrong

ETF premiums and discounts. In fast markets, or for ETFs holding bonds or foreign stocks traded while their home market is closed, the ETF price can drift from the value of its holdings. A market order at the open or in a panic can fill at a poor price. Limit orders help.
Wide spreads on small ETFs. A thinly traded ETF can have a spread that costs more than a year of its fee.
Easy trading invites overtrading. Intraday pricing makes it easy to react to every headline. Mutual funds’ once-a-day price is, for some people, a useful speed bump. See investor behavior mistakes.
Complex ETFs. Leveraged and inverse ETFs reset daily and can behave very differently from what their names suggest over longer periods.
Short-term trading fees. Many mutual funds charge a fee if you sell within a short window after buying.
Legacy DSC units. Canadians who bought DSC units before June 2022 may still face a redemption schedule. Check before selling.

The short version

A mutual fund is priced once a day and bought from the fund company. An ETF trades on an exchange all day, kept near its holdings’ value by authorized participants creating and redeeming units. In the US, in-kind redemptions usually make ETFs more tax efficient in taxable accounts. In Canada, what matters most is the MER and whether it includes a trailing commission for advice you may or may not be getting. Compare the total cost, not the label.