Exchange-traded funds (ETFs) are a pool of assets professionally managed to a stated, specific investment objective, much like traditional, open-end mutual funds. ETFs and mutual funds can both be great vehicles for investors to achieve diversified exposure to a wide array of asset classes. Where they mainly differ is how they’re created and redeemed and how they’re traded. These differences and how they can affect outcomes are driving ETF growth as well as asset flows from mutual funds to ETFs.
How Are ETFs Different From Mutual Funds?
ETFs trade similarly to stocks, which is quite different from how mutual funds trade. Mutual fund trades can be submitted anytime throughout the day, but are only executed after market close once the fund’s net asset value (NAV) has been calculated. ETF trades, on the other hand, can be executed throughout the day at real-time prices and can even be executed during extended-hours trading. All mutual fund trades involve a fund manager. Buys add cash to the fund for the manager to invest and sales take cash out of the fund, potentially causing the manager to sell securities they wouldn’t otherwise choose to sell. The ETF manager doesn’t necessarily need to get involved in ETF trades because ETF investors can trade among themselves on the stock exchange without their actions impacting the underlying fund holdings. If an imbalance between the buys and sells of an ETF arises, a mechanism is in place to manage demand for the ETF through a unique creation and redemption process. This process allows the investor to liquidate their ETF holding without the ETF manager necessarily having to sell the underlying securities.
Because ETFs trade similarly to stocks, they can be shorted, and investors can benefit from many brokerage firms not charging commissions on stock trades. Brokerage firms still charge commissions on some mutual fund trades, depending on the brokerage firm’s agreement with the mutual fund company. ETF investors also are not subject to the potential for a myriad of additional charges, such as front-end loads, back-end loads, 12b-1 distribution fees, or short-term redemption fees that some mutual fund investors pay. Not all mutual funds may be available to trade with a specific brokerage firm, and purchases may be subject to minimum purchase amounts, or an investor may need to meet certain qualifications. ETF investors will not face these challenges, but ETF trades must frequently be executed in whole-number shares. Mutual funds can be traded in dollar amounts or share amounts, including fractional share amounts. From a trading perspective, ETFs have an edge over mutual funds in many cases.
Capital Gains & ETFs
Over the past decade, there has been significant growth in ETFs, while mutual funds have coincidentally experienced strong outflows. According to Morningstar Direct, ETF net inflows reached nearly $900 billion in 2024 while mutual fund net outflows reached over $400 billion.1 One cause of this shift has been the relative tax efficiency offered by ETFs.2 Mutual funds and ETFs can aid investors in building diversified portfolios, but investors give up some control over the tax consequences stemming from their investment holdings. When investors buy and sell individual securities such as stocks and bonds, they’re in control of when to sell a security and potentially realize a capital gain, which they’ll then have to pay tax on. Investors do not have the same level of control with mutual funds and ETFs. Mutual funds and ETFs are required to distribute their income and net realized capital gains to shareholders each year to comply with U.S. tax laws and not be taxed at the fund level. If investment changes were made within a fund during the year such that a net capital gain is realized, that will result in the investor receiving a capital gains distribution they will then pay tax on, even if they didn’t sell any of their holding that year. Investors may even have to pay tax on a capital gains distribution in a year such as 2022, when most investors lost money.
Turnover of the investments within the fund, investors leaving the fund, forcing asset sales, or a combination of the two, would be expected to substantially increase the odds of a capital gains distribution regardless of the performance of the fund for that year. While it’s possible for ETFs to have capital gains distributions, it’s quite uncommon. The unique creation and redemption process used by ETFs allows the investor to liquidate their ETF holding without the ETF manager necessarily having to sell the underlying securities and trigger realized gains for the ETF. In-kind transactions may not be allowed in certain cases, or the manager may have difficulty trading complex securities in kind, which could lead to a capital gains distribution from an ETF. According to Invesco, 64% of U.S. equity mutual funds paid a capital gain distribution in 2024.3 The average annual distribution from these funds ranged from 5% to 8% of the fund’s net asset value over the past 10 years. Comparatively, only 2% of ETFs distributed a capital gain greater than 1% in 2024. As investors become more aware of the added after-tax costs of mutual funds, the benefits of ETFs are clear.
Increased Adoption of ETFs
Several shifts have occurred in the marketplace over the last decade that paved the way for greater ETF adoption. In 2019, the SEC adopted a rule that modernized the regulation surrounding ETFs by establishing a clear and consistent framework and reducing the time or expense associated with launching a new ETF. As a result, the number of U.S. ETFs doubled from 1,900 in 2019 to 3,800 by 2024. In 2021, the SEC approved one asset manager’s plan to convert $30 billion worth of mutual fund assets to ETFs of the same strategy.
When to Consider Mutual Funds
With the advantages offered by ETFs, why would investors continue to hold or buy mutual funds? Investors may want to use a specific, actively managed strategy in their portfolio and that strategy may not be offered in an ETF version. The tax advantages of ETFs are irrelevant within tax-advantaged accounts such as individual retirement accounts (IRAs), Roth IRAs, 401(k) plans, and the like. If an investor is holding a mutual fund in a taxable account and that holding has a substantial unrealized gain, the investor may determine it isn’t worth it to switch because of the tax consequences of liquidation. However, this dynamic could change. In September 2025, the SEC approved an asset manager’s plan to offer dual share classes, in which a fund may be offered in both mutual fund and ETF format. Some asset managers may even allow investors to seamlessly convert certain mutual fund share classes to equivalent ETFs without any additional tax consequences. Industry leaders expect this trend to continue as more asset managers offer both versions of their funds for added flexibility and tax efficiency.
The recent regulatory changes, as well as ongoing innovation by the asset management industry, will likely continue to fuel the increased adoption of ETFs by investors and drive asset flows from mutual funds to ETFs.
How Forvis Mazars Private Client Can Help
Understanding tax implications and consequences is an important part of any financial strategy. Our teams are passionate about providing integrated tax, planning, and wealth management services synchronized to help meet your needs. We don’t just manage investments; we look deeper to help identify both risks and opportunities for those we serve and are focused on helping our clients thrive. If you have any questions or need assistance, please reach out to a professional at Forvis Mazars.
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