Mutual funds and exchange-traded funds are similar types of investment vehicles. Both allow investors to diversify their investment across a large number of securities, but their differences give exchange-traded funds several important advantages.
A mutual fund is an investment fund that pools money from many different investors to purchase specific securities. Flows in to and out of the fund are valued each day at the 4:00 p.m. closing of the stock market. Mutual fund managers later decide what to purchase or sell within the fund.
An exchange-traded fund (ETF) is an investment fund that trades throughout the day like a stock. Market makers provide fractional shares of the underlying securities to keep share prices of the ETF close to the net asset value of the underlying securities.
ETFs have at least a dozen significant benefits over mutual funds.
1. Little or No Capital Gains Until You Decide to Sell ETF
Mutual funds can kick off capital gains in a taxable account as the underlying fund composition changes. Since shares of an ETF are assembled when you purchase a share and are not disassembled until you sell, capital gains are not realized until you decide to sell the ETF.
2. Little or No Potential Capital Gains Exposure
Mutual funds can be sitting on significant unrealized capital gains when you purchase the fund. The fund value may go down, and if appreciated positions are sold you may be saddled with both losses and realized capital gains. Since a share of an ETF is assembled when you purchase the ETF, there is no risk of potential capital gains exposure. (For related reading, see: How Tax Treatments of ETFs Work.)
3. Transparency of ETF Securities
Mutual funds are only required to disclose their portfolio quarterly and even then the disclosure can lag by 30 days. With a mutual fund you are not sure what the fund is actually holding at any given time. Since shares of an ETF must be assembled when you purchase them, the list of securities that comprise a share must be disclosed, usually on a daily basis.
4. Little to No Style Drift
Mutual funds, especially actively managed mutual funds, can and often do invest in whatever opportunity the manager wants. For those who ascribe to some version of the efficient market hypothesis and believe in modern portfolio theory or factor investing, active management is detrimental to portfolio construction. If a fund has been purchased to fulfill a specific role in a portfolio, investors don’t want the style of that fund to drift. ETFs based on indexes experience little or no style drift. (For related reading, see: Style Drift Can Hurt Mutual Fund Returns.)
5. Lower Expense Ratios
Generally speaking, exchange-traded funds have a lower expense ratio than comparable mutual funds.
6. Lower Trading Costs
With many custodians, the cost of buying or selling an ETF is much lower than buying or selling a mutual fund. One popular custodian, for example, currently charges $4.95 for equity trades, including ETFs, and $25 to $50 for purchasing mutual funds such as Vanguard funds. And while many custodians have a list of ETFs and mutual funds with no transaction fee, the mutual funds on that list often have higher expense ratios, a piece of which are used to pay the custodian for the privilege of being on the list.
7. No Minimum Initial Investment
Sometimes a mutual fund will have a minimum initial investment. With an ETF you can buy a single share. This is especially helpful for low-cost ETFs with no transaction fee.
8. Traded Throughout the Day
When you purchase a mutual fund, you receive a price based on the 4:00 p.m. valuation of the fund's assets. ETFs on the other hand can be traded throughout the day.
9. Hold Less Cash
Mutual funds can and often do hold significant amounts of cash as shares are purchased or redeemed. ETFs do not need to hold cash as the component shares are assembled or disassembled with purchases or redemptions.
10. ETFs Support Trading Options
Since ETFs act like securities, they can support options. You can, for example, sell an ETF short or buy or sell a put or call on an ETF. While trading options is not often advisable, it is at least supported with ETFs. (For related reading, see: Hedging With Puts and Calls.)
11. Based on an Index
Although there are a few actively managed ETFs, most ETFs are based on an index. Many of the perceived benefits of ETFs stem from being based on an index, including their lower expense ratios. Some mutual funds are also based on an index and therefore share some of the same benefits as ETFs. Even for those who believe in index investing, there are tens of thousand of indexes to choose from. The S&P 500 is just a single cap-weighted index representing only a selection of large cap U.S. stocks. According to the Modern Portfolio Theory, a diversified portfolio of non-correlated assets will outperform the risks they take as a group.
12. Should Have a More Consistent Return
Since an ETF is based on an index it will probably have a more consistent return for the category it is invested in. An actively managed mutual fund will over or under weight stocks within an index. This will produce a return which may be wildly better or worse than the index. Proponents of the efficient market hypothesis would argue that this diversity of returns is just as likely to wildly underperform as it is to overperform. This fund randomness is in addition to the normal volatility of the index itself.
Potential Disadvantages of ETFs
ETFs have only a few disadvantages, and none of these limitations are as significant as the advantages.
1. Have a bid-ask spread: Since ETFs are assembled and disassembled by authorized participants, these companies bid on how much they will charge to assemble a share or how much they will pay to disassemble a share. This bid-ask spread is usually very small, but occasionally the spread for a specific ETF can be larger than normal.
2. Are not actively managed: While many financial advisors would view not being actively managed as an advantage, some would argue the opposite. Many expensive funds are sold on the idea that they are worth it because they have a manager who has supposedly beaten the market over a long period of time. There are at least two common ways that managers beat the market over a long period of time. (For related reading, see: Active vs. Passive ETF Investing.)
The first is to start multiple funds, knowing that by random chance some of them will wildly beat the market while others will significantly underperform. Fund companies can then close the underperforming funds and are left with nothing but supposedly exceptional funds. This technique of obfuscation discounts the graveyard of closed mutual funds.
The second method of beating a benchmark is to consistently include enough stocks from a better performing sector to boost returns without including enough to be compared to a different index. For example, a fund could invest 80% of its assets in S&P 500 companies. This is significant enough that it will probably be measured against an S&P 500 Index. The remaining 20% could be invested in mid-cap value stocks. Since mid-cap value generally have better returns than the S&P 500, the fund as a whole is likely to outperform its S&P 500 Index. In addition, if the fund is burdened with higher than normal fees, it would be beneficial to allocate 80% of your money in a low-cost S&P 500 fund and the remaining 20% in a low cost mid-cap value fund. This blend of two low-cost index funds would likely have a better return than the so-called actively managed fund.
(For related reading, see: Mutual Fund vs. ETF: Which Is Right for You?)