Mutual Fund vs. ETF: An Overview
Mutual funds and exchange-traded funds (ETFs) have a lot in common. Both types of funds consist of a mix of many different assets and represent a common way for investors to diversify. There are key differences, though, in the way they are managed. ETFs can be traded like stocks, while mutual funds only can be purchased at the end of each trading day based on a calculated price. Mutual funds also are actively managed, meaning a fund manager makes decisions about how to allocate assets in the fund. ETFs, on the other hand, usually are passively managed and based more simply on a particular market index.
According to the Investment Company Institute, there were 8,059 mutual funds with a total of $17.71 trillion in assets as of Dec. 2018. That's compared to the ICI's research on ETFs, which reported a total of 1,988 ETFs with $3.37 trillion in combined assets for the same period.
- Mutual funds usually are actively managed to buy or sell assets within the fund in an attempt to beat the market and help investors profit.
- ETFs are mostly passively managed, as they typically track a specific market index; they can be bought and sold like stocks.
- Mutual funds tend to have higher fees and higher expense ratios than ETFs, reflecting, in part, the higher costs of being actively managed.
- Mutual funds are either open-ended—trading is between investors and the fund and the number of shares available is limitless; or closed-end—the fund issues a set number of shares regardless of investor demand.
- The three kinds of ETFs are exchange-traded open-end index mutual funds, unit investment trusts, and grantor trusts.
Mutual Funds Vs ETFs
Mutual funds typically come with a higher minimum investment requirement than ETFs. Those minimums can vary depending on the type of fund and company. For example, the Vanguard 500 Index Investor Fund requires a $3,000 minimum investment, while The Growth Fund of America offered by American Funds requires a $250 initial deposit.
Many mutual funds are actively managed by a fund manager or team making decisions to buy and sell stocks or other securities within that fund in order to beat the market and help their investors profit. These funds usually come at a higher cost since they require a lot more time, effort, and manpower.
Purchases and sales of mutual funds take place directly between investors and the fund. The price of the fund is not determined until the end of the business day when net asset value (NAV) is determined.
Two Kinds of Mutual Funds
There are two legal classifications for mutual funds:
- Open-Ended Funds. These funds dominate the mutual fund marketplace in volume and assets under management. With open-ended funds, the purchase and sale of fund shares take place directly between investors and the fund company. There's no limit to the number of shares the fund can issue. So, as more investors buy into the fund, more shares are issued. Federal regulations require a daily valuation process, called marking to market, which subsequently adjusts the fund's per-share price to reflect changes in portfolio (asset) value. The value of an individual's shares is not affected by the number of shares outstanding.
- Closed-End Funds. These funds issue only a specific number of shares and do not issue new shares as investor demand grows. Prices are not determined by the net asset value (NAV) of the fund but are driven by investor demand. Purchases of shares are often made at a premium or discount to NAV.
It's important to factor in the different fee structures and tax implications of these two investment choices before deciding if and how they fit into your portfolio.
Exchange-Traded Funds (ETFs)
ETFs can cost far less for an entry position—as little as the cost of one share, plus fees or commissions. An ETF is created or redeemed in large lots by institutional investors and the shares trade throughout the day between investors like a stock. Like a stock, ETFs can be sold short. Those provisions are important to traders and speculators, but of little interest to long-term investors. But because ETFs are priced continuously by the market, there is the potential for trading to take place at a price other than the true NAV, which may introduce the opportunity for arbitrage.
ETFs offer tax advantages to investors. As passively managed portfolios, ETFs (and index funds) tend to realize fewer capital gains than actively managed mutual funds.
ETFs are more tax efficient than mutual funds because of the way they are created and redeemed.
Mutual Fund vs. ETF Example
For example, suppose an investor redeems $50,000 from a traditional Standard & Poor's 500 Index (S&P 500) fund. To pay the investor, the fund must sell $50,000 worth of stock. If appreciated stocks are sold to free up the cash for the investor, the fund captures that capital gain, which is distributed to shareholders before year-end. As a result, shareholders pay the taxes for the turnover within the fund. If an ETF shareholder wishes to redeem $50,000, the ETF doesn't sell any stock in the portfolio. Instead, it offers shareholders "in-kind redemptions," which limit the possibility of paying capital gains.
Three Kinds of ETFs
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. Some examples of this structure include the QQQQ and Dow DIAMONDS (DIA).
- Exchange-Traded Grantor Trust. This type of ETF bears a strong resemblance to a closed-ended fund, but an investor owns the underlying shares in the companies in which the ETF is invested. This includes having the voting rights associated with being a shareholder. The composition of the fund does not change, though. Dividends are not reinvested, but they are paid directly to shareholders. Investors must trade in 100-share lots. Holding company depository receipts (HOLDRs) is one example of this type of ETF.