Brief Introduction to ETFs:
Exchange-traded funds (ETFs) have taken the investing markets by storm and are now one of the most important and valuable products for wealth creation in recent years. Even with the rise of ETFs, mutual funds are older, long established and with more than $18.4 trillion in assets as of October 2018, mutual funds dwarf exchange-traded funds. However, in 2019, the mutual fund market has grown less than 1%, compared to nearly 7% growth for ETF assets, so ETFs are closing the gap.
Brief Introduction to Mutual Funds:
Mutual funds are investments made up of a pool of money collected from many members of the investing public to buy securities such as stocks, bonds, money market instruments, and other assets. It is most likely that you have already had some experience with mutual funds.
For a more in-depth look into ETFs and mutual funds, follow the links What is a Mutual Fund and What are ETFs.
So, which type of investment is right for you? The answer is: it all depends on your risk tolerance, investment style and personal goals. Both funds have advantages and disadvantages, and before investing it is important to understand the similarities and differences between the two.
Similarities of Mutual Funds and ETFs:
Mutual funds have several similarities to ETFs and are often used for similar purposes. They are both pools of investments that focus on a given investment objective, and investors can buy shares at relatively little cost, to gain a widespread and diversified portfolio.
Index mutual funds track a specific underlying index, such as the S&P 500, as do passively managed exchange-traded funds. However, there are more actively managed mutual funds than there are actively managed ETFs.
Just like ETFs, mutual funds pass their costs through to their investors including tax liabilities, and the expenses for index mutual funds are fairly similar to what an ETF investor would pay. However, this is where this similarity ends, because many mutual funds charge more to investors than do ETFs. Actively managed mutual funds typically charge approximately 1% of investors’ assets – every year. That compares to less than a tenth as much for a wide variety of ETFs, as well as index mutual funds.
This disparity in cost and the subsequent drain on investment returns, is one of the biggest contributors to the relative growth of the ETF industry compared to mutual funds.
Differences Between Mutual Funds and ETFs:
There are important differences between mutual funds and ETFs too.
One primary difference between ETFs and mutual funds is in the way the funds themselves are traded, which has a few implications for investors. Mutual funds are bought and sold directly from the mutual fund company at the current day’s closing price, the Net Asset Value (NAV).
The price of a mutual fund does not change during the course of the day, since they are traded after the market has closed. ETFs, however, are bought and sold like stocks throughout the day, and can take advantage of market swings that take place during trading hours.
Inverse ETFs can be sold short in anticipation of the price dropping, whereas mutual funds cannot.
Passive vs Actively Managed:
Most mutual funds can be broken down into two groups. Actively managed mutual funds are managed by a professional money manager, together with a team of analysts who continually reviews the portfolio, to allocate the fund’s assets and produce capital gains and income for the fund’s investors.
The second type of mutual fund are passively managed accounts and tracks indexes such as the DOW 30 or the S&P 500. As the index rises and falls, the fund will also rise and fall in value as it continues to track the index. These types of mutual funds are lower cost and offer greater diversification, as there are no active fund managers looking after the portfolio; it just tracks the index.
Most ETFs are index funds and are passively managed, following an underlying index in the market such as the S&P 500 Index. You don’t need to find one company that outperforms: you can buy the whole index.
Commissions and Fees Matter:
All mutual funds have expenses that include commissions, redemption fees and operational costs. Commissions, or loads as they are sometimes called, are either front-ended: meaning that you pay a commission when you buy, or back-ended: meaning that you pay a commission when you sell. There are also no-load or non-commission mutual funds which are more popular.
Redemption fees are designed to discourage excessive turnover and are only charged if the fund is sold prior to a specific period of time. The intention is to discourage short term speculation and trading, and to encourage long term investment.
Operational fees include managements’ expertise and miscellaneous fees such as for advertisement or distribution expenses. Mutual fund annual expenses can range on average from as little as 0.1% to as much as 3% or more per year. These expenses are somewhat hidden and are not included on the monthly statements available to investors, yet they can impact on your overall return.
Mutual funds typically come with a higher minimum investment requirement than ETFs.
If you’re planning on making regular contributions to your fund. Mutual funds are available with no transaction fees and no sales commissions. Because ETFs are traded on the open market during the day, they come with trading commissions every time you buy or sell.
ETF’s can be more tax effective than mutual funds. An ETF’s ability to decrease or avoid capital gain distributions is achieved in two ways. Unlike mutual funds where shares are redeemed with the fund directly, ETF’s are traded directly on an exchange just like stocks. When one party sells the ETF and another buys, the underlying securities within the ETF are not sold to raise cash for the redemption and consequently, no tax is required. The fund manager can also use the redemption process to sell the most cost-effective stocks through transfers during the redemption or creation process. These characteristics can also mean a difference in the after-tax rate of returns from a mutual fund versus an ETF, even when they both track the same underlying index.
ETFs can vary in liquidity. Broad based ETFs have more trading liquidity than narrow based ETF categories that focus on a specific country or technical sector. The more thinly traded the ETF, the higher the spread between the bid and ask price. When there is little interest and low trading volumes, the spread increases and investors may have to pay a price premium to own it. Mutual funds, on the other hand, can be bought or sold without concern for the spread or liquidity of the market, but again, can only be bought or sold at the end of day.
It is important to speak to a financial advisor before making any investment decision, as taxes vary from country to country.
There are two legal classifications for mutual funds:
- Open-End Funds. These funds dominate the mutual fund marketplace both in volume and assets. The purchase and sale of shares take place directly between investors and the fund company. There is no limit to the number of shares that the fund can issue. Consequently, as more investors buy into the fund, more shares are issued, and the value of an individual’s shares is not affected by the number of shares outstanding.
- Close-End Funds. These funds issue only a specific number of shares through an initial public offering, and do not issue new shares as investor demand grows. Since these shares are not created nor redeemed, they trade on the open market and are subject to the normal market forces of supply and demand. Purchases of shares are often made at a premium or discount to net asset value (NAV).
There are three legal classifications for ETFs:
- Exchange-Traded Open-End Index Mutual Fund. This fund is registered under the SEC’s Investment Company Act of 1940, whereby dividends are reinvested on the day of receipt and paid to shareholders in cash every quarter. Securities lending is allowed, and derivatives may be used in the fund.
- Exchange-Traded Unit Investment Trust (UIT). Exchange-traded UITs also are governed by the Investment Company Act of 1940, but these must attempt to fully replicate their specific indexes, limit investments in a single issue to 25% or less, and set additional weighting limits for diversified and non-diversified funds. UITs do not automatically reinvest dividends but pay cash dividends quarterly.
- Exchange-Traded Grantor Trust. This type of ETF is similar to a close-end fund, but an investor owns the underlying shares in the companies in which the ETF is invested. Being a shareholder of the company that the ETF is invested in, investors have voting rights. The composition of the fund is not changed, and dividends are paid directly to shareholders.
In summary, which on one is best, the answer is both. mutual funds and ETFs both have their own advantages and disadvantages for creating a wide variety of investment strategies. Fees and commissions should be thoroughly researched. In addition to considering your risk tolerance, investment style and personal goals, you should also extensively research the funds that you are investing in. Having a diversified portfolio may well include both Mutual funds and ETFs, each with different objectives.