What Is a Mutual Fund and how Does It Work?
A mutual fund is a pool of money received from investors that is managed by an investment company. Mutual funds issue and redeem shares at their net asset value (NAV), which is the price at which you can buy or sell a share that is calculated after the market closes for the day. So when you put an order in to buy or sell a mutual fund, it’s not executed until after the market is closed. This is why you can’t specify the price at which you’d like to buy a mutual fund, as the price is unknown until the market closes and the NAV is calculated. Instead, you have to specify the amount you want to invest in a mutual fund, for example $2500 worth of ABCDE mutual fund, and then the quantity of shares you end up with is determined by the NAV.
What Is an ETF and how Does It Work?
ETF stands for exchange-traded fund (literally, traded on the stock exchange) and is a collection of assets that tracks an index. Examples are ETFs that track the S&P 500 or the Russell 2000, a sector like energy or biotech, a country or region like Vietnam or the Caribbean basin, a commodity like gold or coffee, or a currency, among others. ETFs offer more trading flexibility than mutual funds as they trade continuously when the market is open and can be sold short or bought on margin. As such, ETFs are traded at their current market price instead of their NAV, like stocks.
Tax Implications of Mutual Funds and ETFs
Investment returns of mutual funds are granted “pass-through status” under U.S. tax code, meaning that taxes are paid by the investor, not the mutual fund. When capital gains and dividends earned in the mutual fund are paid out to investors, typically once or twice a year, investors are liable for taxes on this income. This can lead to a few undesirable scenarios. One, the investor who just bought shares and receives a distribution is liable for taxes resulting from transactions that occurred before they bought the shares. Two, if the mutual fund loses value, particularly below the price at which it was originally bought, the investor is still liable for taxes on it. In general, owning mutual funds reduces the investor’s ability to manage their taxes.
By contrast, ETFs are more tax-efficient as they are structured to shield investors from capital gains taxes. Redemptions of ETFs do not trigger a stock sale within the fund as they do in mutual funds, so no capital gains or any resulting taxes are passed on to investors. Of course, the investor is still liable for taxes with ETFs if they realize capital gains upon selling them or receive dividends. (For related reading, see: How to Reduce Taxes on ETF Gains.)
Compare the Cost of Mutual Funds and ETFs
Mutual funds are relatively expensive to own. Since they are actively managed by an investment company, the company incurs an array of fees that cuts into returns. These fees can be divided into two main categories. The first category is the operating expenses of the fund, which includes the cost of paying the fund managers, administrative fees, and sales and marketing fees (i.e. 12b-1 fees). These expenses are expressed as an expense ratio, which ranges from 0.2% to 2.0%, and the average mutual fund has an expense ratio of 1.25-1.5%. The second category is front- or back-end loads, which are sales commissions charged upon buying or selling the mutual fund. On the brighter side, there are no-load mutual funds available.
ETFs are significantly cheaper to own. Investors who buy ETFs do so through brokers, rather than buying directly from the fund. As a result, ETFs have lower sales and marketing fees, which translates into lower operating expenses that cut into returns. On the other hand, ETFs come with a trading cost. Unless they are a proprietary fund where the fee is waived, ETFs incur a brokerage commission. (For related reading, see: How ETF Fees Work.)
The cost of buying in can be a deterrent for mutual funds. ETFs are more accessible to investors as they don’t have minimums, whereas mutual fund minimums can range from $5,000 to $50,000.
Investment Strategies of Mutual Funds and ETFs
Mutual funds are run by professional money managers who do the research to make the buying and selling decisions within the fund. The goal of this active management is to beat the market. For some investors, the allure of outperforming the market justifies the higher cost of owning the fund.
ETFs are overseen by professional money managers who try to match the ETF’s performance to its benchmark index. The goal of this passive management is to track the market and not risk underperformance. For some investors, the perceived safety of a passive strategy is more desirable than the heightened uncertainty of an active strategy.
The Bottom Line
Overall, mutual funds offer an active management strategy designed to beat the market at a relatively high cost, whereas ETFs offer a passive management strategy designed to track the market at a relatively low cost. Mutual funds have more trading limitations than ETFs, but there are more mutual funds to choose from than ETFs. Many people want to know, which fund type is better? Not surprisingly, it depends on the investor’s financial situation. (For related reading, see: Mutual Fund or ETF: Which Is Right for You?)
For investors who manage their own portfolios, mutual funds could be preferable for those with a longer time horizon and little interest in trading, and ETFs could be preferable for those who have a shorter time horizon and interest in more frequent trading. When considering taxes, ETFs could be better for investors who are sensitive to taxes. When considering performance, ETFs could be less compromised by fees, but mutual funds could have higher returns. And for investors who use investment managers to manage their portfolios, it is important to take a meta view with either fund type, as the success of the investment strategy is presumably the key determinant. (For more from this author, see: Don't Forget Your Ex-Spouse's Social Security Benefits.)