How mutual funds work
When you invest £500 in a mutual fund, you buy "units" at a price calculated once per day based on the fund’s net asset value (NAV) — the total value of its holdings divided by units outstanding. You buy and sell directly with the fund company (or through a platform), not on a stock exchange. Mutual funds can be actively managed (a fund manager selects stocks trying to beat the market) or passively managed (tracking an index). UK equivalents include OEICs (open-ended investment companies) and unit trusts — structurally slightly different but functionally similar.
Active vs passive management
The vast majority of retail investor assets in the UK and US are in actively managed mutual funds — despite overwhelming evidence that passive alternatives outperform after costs over the long run. An active fund manager must outperform by at least the fee differential to justify their cost. On a 0.75% fee versus a 0.10% passive alternative, they must add 0.65% of outperformance every year — before considering that the evidence shows ~90% fail to do so consistently over 20 years. The case for passive index funds and ETFs is thus both empirical and logical.
Tax considerations
In the UK, both mutual funds and ETFs held within an ISA or SIPP are equally tax-efficient (no capital gains tax, no income tax on dividends). Outside a tax wrapper, ETFs can have slight advantages in some structures due to lower portfolio turnover (which would trigger embedded capital gains). In the US, ETFs are generally more tax-efficient than mutual funds due to the "in-kind redemption" mechanism that avoids distributing capital gains. For most UK retail investors using ISAs and SIPPs, the tax difference is negligible — cost is the dominant factor.
“The investor’s chief problem — even his worst enemy — is likely to be himself. But both mutual funds and ETFs lose almost nothing to this problem if the investor simply buys and holds.”
What this means for you
For most retail investors building long-term wealth, the choice between a low-cost passive mutual fund and a low-cost passive ETF is far less important than the choice between active and passive, and between high and low costs. If you are starting out and want to invest monthly without worrying about bid-offer spreads or market timing, a simple platform like Vanguard, Fidelity, or iWeb offering low-cost index funds may be simpler. If you want more control and are making larger, less frequent investments, a low-cost ETF from a standard broker works equally well. The critical number is the ongoing charge — keep it below 0.25%.