Mutual funds and exchange traded funds (ETFs) are among the most popular types of investments for individuals. Look at the typical 401k, IRA, or taxable portfolio account of any random investor. You are likely to see a healthy dose of mutual funds and ETFs.
The reason such investments are so popular is that they provide instant and somewhat effortless diversification. So much so, that the trick usually is to determine the extent of any overlap. You can gain exposure to a country, industry, sector, or other type of market with a single ETF or mutual fund.
These investments are generally comprised of a pool of funds which is used to purchase investments. These investments are typically publicly traded securities such as stocks and bonds. But they can sometimes also include some more exotic or riskier investments such as options and futures, among others. Investors can buy and sell pieces of the funds generally referred to as “shares” or “units”.
Despite their similarities, mutual funds and ETFs also have their differences. This can make it relatively difficult for some investors to decide which investments to buy. Let’s look at some of these differences.
The modern day type of mutual fund has been around since the earlier part of the twentieth century. However, mutual funds started gaining more popularity as the century progressed during the 1950s and 1960s. By the time the 1980s rolled around, mutual funds were ubiquitous in the investment world. Today, mutual funds account for large portions of many individual investor portfolios.
Actively Managed Mutual Funds
Mutual funds can be actively managed, or they can be index mutual funds, which are passively managed. Actively managed funds generally turn over their underlying portfolio more often. Portfolio managers of these types of funds typically have a goal of beating a specific benchmark index.
For example, the actively traded ABC mutual fund may have the S&P 500 index as its benchmark. As such, the portfolio managers buy and sell securities within the mutual fund in trying to outperform the index. Very few portfolio managers outperform their benchmark indexes on a consistent basis over the long term, especially when accounting for fees and expenses.
Passively Managed (Index) Mutual Funds
Index mutual funds, on the other hand, operate a bit differently. Their underlying portfolios generally do not change much. The reason being is that the mandate of their portfolio managers is to track their benchmark index as closely as possible.
For example, index mutual fund XYZ may have the Dow Jones Industrial Average index as its benchmark. The portfolio managers will purchase securities to create a portfolio which shadows the index. Changes are only made if the index changes. So if a specific stock is replaced in the index by another, the index fund managers will do the same in their fund portfolio.
Over the past few years, investors have been gravitating more towards passively managed index funds in large numbers.
Exchange Traded Funds (ETFs)
Exchange traded funds have also been an investment option for many years now. However, they are a relatively newer type of investment when compared to the mutual fund. ETFs have been around since the early 1990s, and have been gaining in popularity ever since. Although ETFs generally account for a relatively smaller percentage of investor portfolios overall, the industry has seen tremendous growth over the years.
How Are Mutual Funds and ETFs Bought And Sold?
One of the key differences between mutual funds and ETFs is the way in which they are bought and sold.
Mutual Funds Transactions Occur At One Time Each Day
Mutual funds are required to determine their value on a daily basis. This valuation is called the net asset value (NAV). NAV is calculated by subtracting any liabilities of the fund from the value of its investment portfolio assets. This value is then divided by the number of shares outstanding to determine the price of each mutual fund share.
When you buy or sell a mutual fund, you must wait until it is valued at the end of the day to determine the price at which the transaction will occur. If you place your order after the end of the trading day (typically 4PM EST), then your transaction will be executed at the next valuation at the end of the next trading day. Some financial institutions have an earlier cutoff time for placing a mutual fund order during a specific day, which may be a few hours before the close of trading.
So with open-end mutual funds, you can’t know the price at which you will buy or sell shares in advance. However, you can specify a dollar amount which you want to invest or redeem. The number of shares transacted will be known once the valuation is calculated.
Mutual funds may be purchased through a broker. But they can also be purchased directly form the fund company itself.
ETFs Are Bought and Sold Throughout The Trading Day
ETFs on the other hand trade like stocks. Their shares are priced throughout the day based on demand. Also unlike mutual funds, they can be sold short or purchased on margin. Short selling and using margin can be very risky strategies, but are often used by traders and speculators.
ETFs can trade at a premium or discount to their NAV based on supply and demand in the market for the shares. Shares of ETFs must be purchased through a broker.
So if you want a fund investment to trade, ETFs may be the way to go. However, ETFs may also be appropriate long-term investments as well.
Costs and Commissions
When it comes to costs, you must look at operating costs of the fund, as well as transaction costs incurred when buying or selling shares of the fund.
Fund Operating Costs
Operating costs of the fund generally come out of the fund directly. This includes items such as the investment manager’s compensation, marketing fees, and other administrative expenses. Fund costs can be easily compared by looking at each funds “expense ratio.” The expense ratio is generally the proportion of a fund’s operating expenses to its average assets under management (AUM).
ETFs generally have lower expense ratios than mutual funds. And passively managed index funds typically have lower operating costs than actively managed funds. This can make a big difference in long term net investment returns and building up the value of your account over time.
Mutual Fund Transaction Costs
Mutual fund transaction costs are referred to as “loads”. A load is a sales charge which is typically paid on a mutual fund purchase or sale when the transaction occurs through a third party. Sales loads are determined as a percentage of the transaction. However, you can invest in no-load (open-end) mutual funds if you deal directly with the fund company.
Mutual funds can also charge redemption fees upon the sale of shares to discourage short term trading. A redemption fee may be charged if the fund is sold within a specified period of time from the initial purchase.
ETF Transaction Costs
Every time you purchase or sell ETF shares, you will generally pay the broker commission you would otherwise pay on a stock or equity trade. Some brokers now offer certain ETFs on a commission-free basis. However, some also charge a penalty or fee if you sell such an ETF within a specific time frame such as 30 days.
With ETFs, you must also look at any market spread. Since ETFs are traded on exchanges, there will be a bid and an ask price quote at any given time during the trading day. You sell at the (lower) bid price, and buy at the (higher) ask price. Popular ETFs with high trading volume will typically have lower bid/ask spreads.
Reinvestment of Fund Income Distributed to Shareholders
Mutual funds have built in dividend income reinvestment features. You can elect to reinvest the income generated by the fund at no cost, even if you paid a sales charge when you purchased it. New additional investments may incur a sales charge. However, this will not be the case if you invest in a no-load fund.
With ETFs, you traditionally were not able to efficiently reinvest small dividends due to the inability to purchase fractional shares through a broker. Not to mention the commission charge required for additional purchases. However, as with stocks, several brokers now provide a feature where you can reinvest dividends at no cost. New additional investments can also be made at no cost if you happen to invest in an ETF offered by your broker without commission.
So dividend reinvestment is possible with both mutual funds as well as ETFs. However, it is a bit more easily accomplished with mutual funds.
Transparency of Mutual Funds vs ETFs
ETFs are generally more transparent than mutual funds. You can usually see an ETF’s current investment holdings on any given day. Mutual funds, on the other hand, typically report their holdings to shareholders on a quarterly basis. So especially with an actively managed mutual fund, you may not know what moves were made by the portfolio managers until after the quarter ends.
Tax Efficiency of Mutual Funds vs ETFs
ETFs are generally more tax efficient than mutual funds. As such, it may make sense to use ETFs more in taxable brokerage accounts. ETFs may also make more sense if you are in a higher tax bracket. Mutual funds, on the other hand, may be preferable in tax deferred accounts such as IRAs and 401Ks. This way, the income they throw off will not be taxed until a later time.
Mutual Funds Are Generally Less Tax Efficient
Mutual funds are required to distribute out all profits to investors or shareholders. When a mutual fund holds its investments such as stocks and bonds, they may pay income to the fund in the form of interest and dividends.
The fund may also sell its investments. It may sell them to adjust its portfolio, for example. The fund may also need to sell securities to redeem an investor’s shares. This is more likely to happen when the redemptions are significantly greater than the investments of additional money into the fund.
So significant net outflows will generally require selling of investments by the fund. Redemptions can occur for many reasons. The individual investor may need to sell the investment based on their investment objectives. Alternatively, the fund may be performing poorly. They are, however, more frequent and significant during financial crises. Any capital gains income resulting from the fund selling some of its investments must also be distributed to investors.
Actively managed mutual funds will generally be less tax efficient than index mutual funds. Both types of funds may have capital gains due to selling of investments due to redemptions. But the portfolio managers of index funds do not trade the portfolio much otherwise since their only goal is to mimic an index. Active fund managers on the other hand are generally more active traders since they are trying to outperform their benchmark.
Exchange Traded Funds Are Generally More Tax Efficient
ETFs also receive dividends and interest from underlying investments which are passed through to shareholder investors. Also, as with index mutual funds, most ETFs generally track an index. So there isn’t much trading going on of the underlying investments. There are some actively managed ETFs, but they are a small minority when compared to the total number of index tracking ETFs.
When investors in ETFs sell their shares, however, there is no selling of the underlying ETF investments. The shares are just sold to other investors, not back to the fund as with a mutual fund. Sometimes an ETF does need to make a change to its portfolio due to a change in an index. But it will generally do so by swapping the required underlying investment “in kind” with another financial institution.
This means that the investment the ETF wants to eliminate is exchanged for the one they want to replace it with. So there is usually no cash sale and repurchase. This allows for the avoidance of capital gains income.
Equity ETFs are generally more tax efficient than bond ETFs. Stocks do not have a “maturity date.” Bonds, on the other hand, mature at a specific date. As such, this can create some capital gains which can otherwise be avoided by an ETF comprised of stocks only.
Selling Your Fund Shares Can Also Generate Taxable Income
Additional capital gains income may be created when you sell your shares back to the mutual fund. The extent of any gain will be determined by comparing the selling price of each share to the purchase price.
As with mutual funds, you will also have a capital gain if you sell an ETF for more than you purchased it.
Determining your cost basis for shares purchased can be tricky when you reinvest income generated by the fund. This can also be the case if you make several additional investments into the same fund over time. Investment companies and brokers are required to track your basis as of 2011. However, this may still be an issue for funds you may have owned prior to this time.
Both mutual funds and ETFs can be great additions to your investment portfolio. Depending on your situation and investment strategy, one investment may be a better fit than the other. Shorter term investors or traders will likely prefer ETFs.
Longer term investors may look to mutual funds. More so if they are reinvesting the income generated or if they are making small additional investments over time to the same fund. However, ETFs can also be appropriate long term investments with reinvestment options.
Tax sensitive investors may look to ETFs due to their greater tax efficiency. Also ETFs may make more sense in a taxable brokerage account, while mutual funds may be a better fit for a tax deferred retirement account.
Keep in mind however, that these are overall generalizations of these types of funds. Each specific investment’s attributes must be analyzed individually in determining if it is appropriate for your specific goals and objectives.