ETFs vs. Mutual Funds: What’s the Difference
ETFs vs. Mutual Funds: What’s the Difference
The very first open-end mutual fund was created in 1924, over 100 years ago. It was a great stride in the financial industry, as it allowed investors to own a diversified portfolio of stocks in one investment.
More and more were created, and mutual funds dominated the investment landscape for generations. But in 1990, a different kind of fund was created. It was still a basket of stocks (or bonds, etc) like a mutual fund, but it was substantially different in other ways. This investment is called an Exchange Traded Fund, or ETF.
On the surface, ETFs and mutual funds can look almost identical. Both give you diversified exposure to a basket of investments. Both can track indexes or be actively managed. And both can play a role in a well-built portfolio.
But under the hood, they operate very differently—especially when it comes to taxes. And that difference can quietly have a meaningful impact on your long-term returns.
Let’s break it down.
First—What’s the Core Difference?
The first distinction comes down to how they trade. Mutual funds are priced once per day, after the market closes. Whether you place a trade in the morning or the afternoon, you’ll get the same end-of-day price (called the NAV—Net Asset Value).
ETFs on the other hand, trade throughout the day, like a stock does. Prices fluctuate in real time based on supply and demand. This difference alone can be a deciding factor for many—some investors like the simplicity of mutual funds, others prefer the flexibility of ETFs.
But the real story isn’t just about trading. It’s about what happens inside the fund.
The Hidden Difference: How Investors Enter and Exit
Here’s where things start to matter more. With mutual funds: everyone shares the tax bill.
When investors sell out of a mutual fund, the fund manager will typically need to sell underlying investments to raise the cash to cover those sells.
If the investments they sell have gains, then fund itself realizes those gains—and those gains get passed along to all shareholders, even the ones who didn’t sell anything. So, you could be a long-term investor not making any trades, and still wind up with a taxable distribution at year-end, called a capital gain distribution. This can sometimes surprise people.
ETFs: A More Tax-Efficient Structure
ETFs handle this very differently. Since ETF’s trade on an exchange (like a stock), when you sell 1,000 shares of an ETF, that means someone else bought your 1,000 shares. That’s it. The fund itself didn’t need to sell any underlying securities, and that’s why no capital gain was triggered.
That’s a very concise explanation, but for those looking to really look under the hood, let’s dive in a little deeper.
Let’s say you own an ETF, and you need to raise cash so you sell 1,000 shares of it. Here is what happens:
Step 1: Your Trade Happens in the Open Market
When you sell 1,000 shares of an ETF, you’re not selling them back to the fund company.
You’re selling them on an exchange (like the New York Stock Exchange or NASDAQ), just like you would a stock. So, the key point is that another investor is buying your shares. Your cash comes from that buyer, not from the ETF itself.
Step 2: Market Makers Keep Things Running Smoothly
Most of the time, your 1,000 shares are absorbed by a market maker (a large trading firm whose job is to provide liquidity). They might hold the shares briefly, sell them to another investor or bundle them into a larger block.
At this stage, nothing has happened inside the ETF yet. No taxes triggered. No securities sold.
Step 3: When Supply/Demand Gets Out of Balance
Now let’s say there’s more selling than buying overall. Market makers can end up holding a large chunk of ETF shares they don’t want to keep long-term.
This is where Authorized Participants (APs) step in.
Step 4: The “In-Kind Redemption” Process
Authorized Participants are large institutions (think major banks or trading firms) that have a direct relationship with the ETF provider (like BlackRock, State Street Global Advisors, etc).
They operate in large blocks called creation units (often 25,000–100,000 ETF shares).
Here’s what happens:
The AP accumulates ETF shares (including shares like the 1,000 you sold)
Once they have enough (say 50,000 shares), they go to the ETF provider
They redeem those ETF shares
Instead of getting cash, they receive a basket of underlying securities (stocks, bonds, etc.)
This is the “in-kind” part—no selling required.
So again, the ETF didn’t have to sell anything to raise cash. Instead, it simply handed over securities it already owned.
Where Did Your 1,000 Shares Go?
To tie it all together:
You sold your 1,000 shares on the open market
A market maker (or another investor) bought them
Those shares may eventually get bundled into a large block
That block may be redeemed by an Authorized Participant
The AP receives underlying securities—not cash
And at no point did the ETF need to sell holdings and trigger gains.
It’s important to note that it’s still possible that an ETF would need to sell an underlying security, it’s just far less frequent than a mutual fund.
So, what does this all mean? It doesn’t mean ETF’s are inherently better than mutual funds, it just means they tend to be more tax efficient. In retirement accounts, where capital gains aren’t taxed, this is essentially a moot point.
But in taxable investment accounts, ETF’s should be a strong consideration for your portfolio to reduce tax drag. This is why investment selection isn’t just about performance, it’s also about tax efficiency, flexibility, and how everything fits together in your broader financial plan.
Everest Wealth Advisors is a wealth advisory firm that helps individuals, families, and business’s navigate complex financial decisions through personalized, goal based planning and disciplined investment strategies.
Ryan Page, CFP®, MBA®
Office & Text:720-826-1092
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.
This information is not intended to be a substitute for individualized tax advice. We suggest that you discuss your specific tax situation with a qualified tax advisor.
ETFs trade like stocks, are subject to investment risk, fluctuate in market value, and may trade at prices above or below the ETF's net asset value (NAV). Upon redemption, the value of fund shares may be worth more or less than their original cost. ETFs carry additional risks such as not being diversified, possible trading halts, and index tracking errors.
Investing in mutual funds involves risk, including possible loss of principal. Fund value will fluctuate with market conditions and it may not achieve its investment objective.
