ETF vs mutual funds: Which is the better investment?

Mutual funds and exchange-traded funds (ETFs) are two of the most used tools in portfolio construction, and they often look similar at first glance. Knowing how each one works in practice is vital if you want to match investment vehicles with your clients' goals, time horizons, and comfort with risk.

In this article, Wealth Professional will explore the basics of mutual funds and ETFs. We will compare how they are built and managed and look at ease of trading as well as flexibility in portfolio design.

ETF vs. mutual funds: Basic definitions

Let's discuss these two investment types to better understand how they differ:

Mutual funds

Mutual funds are pooled investment funds. They gather money from many investors and invest that pool in securities such as:

• stocks
• bonds
• money market instruments
• a combination of these

Each investor owns units or shares in the fund and participates in the gains and losses of the underlying portfolio in proportion to their holdings. A mutual fund is usually run by a professional portfolio manager or a team. They decide which securities to buy and sell in line with the fund's investment objectives and strategy.

Some mutual funds follow an index and aim to mirror its performance. Many long-standing Canadian mutual funds use an active approach and seek to outperform a benchmark by selecting securities and adjusting sector or geographic exposure.

Mutual fund orders are processed directly with the fund company or through an investment dealer at the fund's net asset value (NAV). It is calculated once per day after markets close.

The NAV is equal to the total value of the fund's assets minus its liabilities, divided by the number of units outstanding. Every investor who buys or sells on a given day receives that same end-of-day price.

ETFs

On the other hand, ETFs are pooled investment funds whose units trade on an exchange in the same way that shares do. Like mutual funds, ETFs gather money from investors and invest in baskets of securities such as equities, bonds, or other assets. The result is diversified market exposure through a single listed security.

Most ETF assets in Canada track market indices. These index ETFs aim to match the return of a specified benchmark by holding the same securities, or a representative sample, in similar weights.

There is also a growing group of active ETFs. In these funds, portfolio managers adjust holdings using their own analysis instead of simply following an index.

ETF units trade throughout the day on exchanges such as the Toronto Stock Exchange (TSX). Investors buy and sell through brokerage accounts. Prices fluctuate during the session based on:

• supply and demand
• market conditions
• value of the underlying holdings

A creation and redemption process involving authorized participants helps keep an ETF's trading price close to its underlying NAV. When an ETF trades at a premium or discount, these participants can exchange units for baskets of the underlying securities or vice versa.

This encourages prices to move back toward fair value. Even so, small premiums and discounts can appear, particularly in less liquid markets or when the ETF holds securities from other time zones.

Watch this video for more on ETFs vs. mutual funds:

ETFs work in some ways like mutual funds, but they differ in many important aspects. ETFs can provide your clients with low-cost index exposure, access to niche segments, and more control over trading and execution.

As for mutual funds, they can provide access to professional management and convenient automatic contribution or withdrawal plans.

ETF vs. mutual funds: Benefits and drawbacks

Here is how the trade-offs of ETFs and mutual funds line up for your day-to-day recommendations:

ETF pros

Here are some ETF advantages that make this investment type appealing to both financial advisors and their clients:

1. Diversification in a single trade

One ETF can give your clients exposure to entire markets, sectors, factors, or regions without security-by-security selection. This helps you build diversified portfolios with fewer individual holdings.

2. Intraday liquidity and pricing

You and your clients can react to cash needs, rebalancing signals, or market events during trading hours instead of waiting for end-of-day pricing. This is because ETFs trade throughout the day like stocks.

3. Lower average MERs

Especially for broad index products, ETFs often cost less than comparable actively managed mutual funds. Over long horizons, even small differences in MER can translate into meaningful differences in outcomes.

4. Tax efficiency in non-registered accounts

Lower turnover and in-kind mechanisms reduce the likelihood of surprise capital gains distributions for your clients holding ETFs in taxable accounts.

The best financial advisors in Canada are able to design good strategies that use a mix of ETFs to achieve steady, tax‑efficient growth.

ETF cons

Despite these strengths, ETFs introduce some risks and practical issues:

1. Bid ask spreads and liquidity

Trading costs for ETFs include spreads as well as any commissions. Securities that track liquid markets with high trading volume usually have tight spreads. Niche or low-volume ETFs can have wider spreads that reduce net returns, especially for frequent traders.

2. Premium or discount risk

ETF units usually trade close to NAV, but that relationship can be stressed during volatile periods or when underlying markets are closed. Short-term premiums and discounts can hurt investors who use market orders at ill-timed moments.

3. Need for trading discipline

Intraday pricing can encourage overtrading for investors who follow every market move. Without guidance, this behaviour can undermine the very cost advantages that drew them to ETFs in the first place.

4. Product complexity in some segments

Leveraged, inverse, commodity, and other specialized ETFs can behave in ways that your clients find hard to predict. These products need careful explanation and, in some cases, might not suit long-term goals.

Mutual funds pros

Mutual funds also offer meaningful benefits, even in an environment where ETFs attract a lot of attention:

1. Ease of use for many households

It is straightforward for your clients to hold mutual funds through banks, insurers, and full-service firms. They can invest fixed dollar amounts and rely on automatic fractional units. They can also avoid having to place trades on an exchange.

2. Automatic plans and rebalancing

Mutual funds lend themselves to regular contribution plans and systematic withdrawals. Combined with balanced or target risk funds, they can offer simple, one-ticket solutions that support discipline for clients who prefer a set-and-review approach.

3. Access to established active managers

Some Canadian and global equity or fixed income strategies are only offered in mutual fund form. When those strategies are a good fit for your clients, mutual funds remain necessary holdings.

4. Automatic reinvestment of distributions

Income and capital gains distributions are easily reinvested into additional units without trading charges, which supports long-term compounding.

Do you have clients who are interested in these funds? Here is a beginner-friendly guide to investing in mutual funds.

Mutual funds cons

When you compare ETFs and mutual funds, the drawbacks of mutual funds tend to relate to cost, tax, and control over trades:

1. Higher MERs in many retail series

Traditional mutual funds with embedded commissions often have higher MERs than similar ETFs. Over time, that cost gap can weigh on performance for your clients.

2. Embedded compensation and fee clarity

When trailing commissions sit inside the MER, it can be harder for your clients to see what portion of costs goes to portfolio management. It can also be harder to see what portion goes to advice and distribution.

Moving to fee-based arrangements with lower-cost series can help, but it requires deliberate change.

3. Taxable distributions in non-registered accounts

Because mutual funds distribute realized capital gains, your clients can face tax bills even if they are buying more units and not reducing their holdings. This is particularly noticeable in mature funds with long histories of portfolio turnover.

4. Trading restricted to end-of-day NAV

For most long-horizon investors, this is not a drawback. But for situations where your clients want intraday execution or specific limit prices, mutual funds do not offer the same control that ETFs do.

ETF vs. mutual funds in Canadian portfolios

Differentiating ETFs and mutual funds is less about crowning a single winner and more about using the strengths of each in the right place. In practice, many advisors use blended approaches.

For example, using low-cost index ETFs for core equity and fixed income holdings with selected active mutual funds for satellite positions. Another is holding tax-efficient ETFs with equity exposure in non-registered accounts. Then, using mutual funds when those funds offer attractive active management or operational simplicity inside registered accounts such as:

• Registered Retirement Savings Plans (RRSPs)
• Tax-Free Savings Accounts (TFSAs)
• Registered Retirement Income Funds (RRIFs)

ETF vs. mutual funds: Which is better?

Choosing between ETFs and mutual funds is a task that can only be answered by analyzing your clients' financial and personal profile. What you need to do now is to identify the investment goals that your clients want to achieve.

In turn, you'll be able to pick which type of investment will be suitable for their preference, needs, and objectives. Remind your clients that investing is not a one-day process. So, whether they choose ETFs or mutual funds, they must be patient in expecting profits, returns, or capital gains from their portfolios.

Discover more on ETFs, mutual funds, and other types of investment when you go to our Investments page