What is the difference between an ETF and a fund?Start here

Mostly how you buy it. An ETF trades on an exchange all day; a mutual fund is priced once. Underneath, they can be exactly the same portfolio.

Both are a pot of money that buys a portfolio, with your share of it recorded in your name. That part is identical, and it is the part that matters most. The differences are in the plumbing around it.

How do I actually buy each one?

An ETF trades on a stock exchange like a share. You can buy it at 10:31 and sell it at 14:05, at whatever the market price is at that moment. There is a bid and an offer, and the gap between them is a cost you pay.

A mutual fund does not trade. You place an order, and once a day the fund works out what everything in it is worth and gives everybody the same price. Orders after the cutoff go into tomorrow's calculation. There is one price and no spread.

Being able to trade all day sounds like an advantage. Whether it is depends entirely on whether you were going to trade all day.

Which one is cheaper?

Broad index ETFs are usually cheaper on the annual charge — often 0.05% to 0.20%, against 0.5% or more for many actively managed funds. But that comparison mixes two things up. It is mostly a comparison of index tracking against active management, not of the ETF wrapper against the fund wrapper.

Compare like with like and the gap narrows a lot. An index mutual fund and an index ETF from the same manager often charge almost the same. And the ETF adds a trading cost the mutual fund does not have: the spread, plus any commission, every time you deal.

For a monthly savings plan of a small amount, that can make the mutual fund cheaper in practice. For a large lump sum held for years, the ETF usually wins.

Can an ETF's price drift away from what it holds?

It can, and there is a mechanism that pulls it back. Large firms called authorised participants are allowed to swap a basket of the underlying shares for new ETF units, and back again. If the ETF trades above what it holds, they create units and sell them; if below, they buy units and take the shares out. The profit motive keeps the two prices close.

It works well for liquid markets and less well when the underlying market is closed or has stopped trading — which is precisely when people want to sell. An ETF of easily traded shares almost never drifts. An ETF of things that trade rarely can, sharply, in a bad week. What liquidity costs is about that gap.

Is one safer than the other?

Structurally they are the same: both hold the assets separately from the manager's own money, and if the manager fails the portfolio is still yours. Both are regulated funds.

The thing to check is not ETF versus fund but whether the product actually holds anything. Some funds get their exposure through a swap rather than by owning the shares, and a few products with similar names are not funds at all — an ETC or ETN is a promise from an issuer. Same three letters at the start, different thing entirely.

So which should I choose?

• Investing a lump sum, or trading occasionally: the ETF is usually cheaper.
• Paying in small amounts every month: check whether commission and spread outweigh the lower annual fee.
• Worried you will fiddle: a fund priced once a day removes the temptation, and that is a real feature.
• Either way, look through the wrapper at what is actually held.

ETF vs fund vs certificate puts all three side by side.