As an investor, you are tasked with understanding the different investment vehicles available in order for you to be able to make well-informed decisions. Each asset class and investment type has its pros and cons, and it is knowing those pros and cons that will help you navigate the investment world with confidence. When it comes to funds, there are two primary investment vehicles that investors flock to: ETFs (Exchange-traded funds) vs Mutual Funds.
While the two have a lot of similarities, they also have noticeable differences. It’s a good idea to know the key differences rather than getting caught up in the granular details. After reading this article, you will have a clear understanding of the mechanics behind ETFs and Mutual Funds, along with some of their key differences.
Before we continue, Financial Professional wants to remind you that all materials in this article are educational in nature. This article is not meant to be interpreted as investment advice. Always consider your personal situation – and the help of a licensed financial professional – when making any investment decisions.
What is an ETF?
An Exchange Traded Fund (ETF) is a fund that you can purchase on an exchange which tends to mirror the performance of a particular sector, asset class, country, etc.
Active vs Passive ETFs
While there are a handful of active ETFs, the majority of ETFs are passive in nature. “Passive” means that the fund is designed to provide you with the same performance as the underlying investment(s) owned by the fund.
For example, SPY is a well-known ETF that tracks the performance of the S&P 500. Because SPY owns the same stocks in the S&P 500 index, in equal proportion to the index, you will experience the same level of gains and losses as the index. In other words, if the S&P 500 is up 10% and you’ve held SPY over the same time period, you should expect your gains to be up 10% as well.
ETFs as a Cheap Investment
ETFs are very popular because the majority of them are cheap to own and trade just like stocks.
For example, consider VOO, which is Vanguard’s S&P 500 ETF. VOO has an expense ratio of 0.03%, or 3 basis points. That is very, very cheap for a fund of any kind.
Why is it so cheap? Vanguard is not trying to provide you with alpha, or excess returns, with this fund. The only objective is to provide you with the exact same performance as the S&P 500. If the fund mirrors the returns of the index perfectly, it is doing its job. Because less work goes into mirroring an index, the fund is offered at a very inexpensive cost.
Bid and Ask Spread
When you are looking to trade an ETF, you have to be mindful of the bid and ask spread. As a reminder, that is how investments are quoted when they are listed on an exchange and can be traded through a broker. The spread is the difference between the ask (the lowest price that you can purchase an investment at) and the bid (the highest price that you can sell the investment for). For example, if an ETF is quoted at $55.05 bid/$55.10 ask, the spread would be $0.05.
Depending on how liquid the fund is, the spread may vary. Funds that are more actively traded than others tend to have thinner spreads than funds that are less actively traded.
A Few More Points on ETFs
For those new to the ETF game, there are a few more key details of which to be aware:
- Like stocks, ETFs can be shorted. There are also derivatives available for ETFs, unlike mutual funds.
- ETFs are traded on the secondary market, meaning that they are traded between investors. When you sell your shares of an ETF, another investor is buying them, not the fund company.
- ETFs do not have investment minimums. In some cases, you can even purchase fractional shares of an ETF if your broker allows for it.
- Unlike mutual funds, ETFs do not offer “breakpoints”, or discounts for purchasing shares in bulk. In other words, what you get is what you pay for.
- ETFs pay out dividends if the underlying investments do, but the funds do not pay out capital gains distributions. If the ETF is passive in nature, there is not a whole lot of trading that is done by the fund manager. As such, there are no capital gains to redistribute to shareholders. This tends to be an important consideration for investors that are seeking to construct a tax-efficient portfolio of brokerage assets.
What is a Mutual Fund?
A mutual fund is very similar to an ETF in that it is offered and managed by an investment company. However, there are several notable differences. First, let’s describe what a mutual fund is.
A mutual fund is a fund that is offered by an investment company, which manages the fund. Mutual funds are managed by a team of professionals, according to a specific strategy. For example, the DODIX fund offered by Dodge and Cox is a mutual fund that is designed to preserve principal while providing investors with income via fixed income securities and cash equivalents.
As a shareholder of the fund, you directly participate in the performance of the fund, depending on how well (or poorly) the mutual fund is managed.
Mutual funds can be active or passive, like ETFs. However, most mutual funds are known to be active in nature. This means the management team is actively looking to provide shareholders of the fund with excess returns (alpha) compared to a specific benchmark, like a sector. Because extra work goes into running an active mutual fund, these funds tend to come with higher internal expenses.
A mutual fund is also required to pay out capital gains distributions to its shareholders. This means that shareholders receive proceeds from the trades made by the fund manager, and have to pay capital gains tax on those proceeds. Again, if you are tax-sensitive, you may want to consider owning mutual funds in a tax-deferred account, such as a 401k or an IRA, to avoid current taxation of these distributions.
Trading Mutual Funds
The process behind trading mutual fund shares also can vary compared to ETFs. The first thing to consider is whether the fund is closed-ended or open-ended.
Open-ended funds only trade at the close of the trading day, when the Net Asset Value (NAV) of the funds are calculated. If you own open-ended funds, they will trade at this Net Asset Value at the end of the day.
When trading an open-ended fund, you will buy shares directly from the mutual fund company and sell them directly back to the company. The process of selling your shares to the fund company is referred to as “redemption”. Because you are dealing directly with the fund company, there is no bid/ask spread when purchasing or redeeming open-ended fund shares.
Notice how this is different from ETFs, which tend to trade on the secondary market.
There are also closed-ended mutual funds, which trade on the secondary market and are not necessarily traded at the fund’s NAV.
Mutual funds also tend to carry sales loads, which are commissions paid by the investor when purchasing shares of a mutual fund. The commission itself depends on what is known as the share class. It is recommended you research these commissions more in depth prior to purchasing or selling mutual fund shares, but for a quick breakdown:
- A shares tend to carry an up front load
- B shares have a back end load
- C shares have a level load
Mutual Fund vs ETFs: Similarities
Some of the most notable similarities between ETFs and Mutual Funds include:
- Instant Diversification: You don’t own a single company (just be mindful of industry concentration)
- Convenience: You don’t have to purchase every single security held by the fund
- Professionally managed: All fund management is handled by the fund company
- Access: You will get direct access to the asset class, sector, economy that the fund invest in
- Income: If the underlying investments owned by the mutual fund or ETF pay out a dividend or interest, you will receive that income in your portfolio
Mutual Fund vs ETFs: Differences
Some of the key differences between mutual funds vs ETFs include:
- ETFs do not come with sales loads. You only pay internal expenses and brokerage commissions if applicable
- Mutual Funds tend to carry sales loads, management expenses and 10b5 expenses as well
- The Spread
- The spread only applies to investments traded on an exchange (ETFs and closed-end mutual funds)
- Open-end funds are bought and redeemed directly from the fund company
- Only mutual funds offer “breakpoints,” or discounts for purchasing a certain amount of shares in bulk
- Only mutual funds allow you to exchange shares of funds between fund families offered by the same fund company
- While there are actively managed ETFs and passively managed mutual funds (index funds), ETFs tend to be more passive than mutual funds
- Investment Minimums
- ETFs do not require an initial minimum investment. Some brokers allow you to purchase fractional shares.
- Most mutual funds require a minimum investment (although it may be as low as $1)
- Capital Gains Distributions
- Mutual funds are required to pay out capital gains distributions so the fund itself is not taxed on the sale of investments. As a shareholder in the fund, you receive those distributions and have to pay taxes on them if the funds are held in a brokerage account
- ETFs do not pay out capital gains distributions
A Final Word on Mutual Fund vs ETFs
Whether you own strictly ETFs, mutual funds, or a combination of the two, you can still be successful as an investor. The key is to have a clearly defined strategy that you stick to consistently.
Remember, each investment vehicle has pros and cons. There is no one investment vehicle that is always going to be superior than another. While active mutual funds have been criticized for their inability to outperform their benchmarks, there are still funds out there that perform very well. And, while ETFs are known for being cheap, there are still funds out there that are unnecessarily expensive.
It’s important to do your due diligence in research to understand the costs and risks associated with any specific investments you add to your portfolio. It’s also crucial that you keep in mind not only your financial goals but your personal circumstances as well.
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