Exchange-traded funds (ETFs) were once described as the new kids on the investment block, but today, they are giving traditional mutual funds a run for their money. There's no denying that both ETFs and mutual funds are viable choices for investors.
According to the Investment Company Institute, there were 8,059 mutual funds with a total of $17.71 trillion in assets as of December 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.
But, with so many mutual funds and ETFs available on the market, it's important for investors to familiarize themselves with the differences between products to ensure they are making appropriate investment decisions. In the mutual fund vs. ETF debate, investors must consider the shared traits, as well as the differences between the two when deciding which to use.
Read on to find out more about the nuances of each.
Initial Investment Requirements
One of the key considerations anyone has to make about their investment vehicles is how much it will cost to enter the market. 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.
ETFs, on the other hand, can be purchased like stocks, so they cost far less for an entry position — as little as the cost of one share. This, of course, doesn't include any fees or commissions that may be added on top of the price of one ETF share.
There is also a big difference between how the two investment vehicles are managed. Many mutual funds are actively managed. Here, a fund manager or team makes 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. ETFs, though, are typically managed passively, which means they are set up to track a specific index and are not monitored by a specific fund manager.
ETFs offer greater flexibility than mutual funds when it comes to trading. Purchases and sales of mutual finds take place directly between investors and the fund. The price of the fund is not determined until the end of business day when net asset value (NAV) is determined.
An ETF, by comparison, 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.
Due to the passive nature of indexed strategies, the internal expenses of most ETFs are considerably lower than those of many mutual funds. Of the more than 1,900 available ETFs, expense ratios ranged from about .10% to 1.25%. By comparison, the lowest fund fees range from .01% to more than 10% per year for other funds.
Another expense to consider is the product acquisition costs if any. Mutual funds can often be purchased at NAV, or stripped of any loads, but many (they are often sold by an intermediary) have commissions and loads associated with them, some of which run as high as 8.5%. ETF purchases are free of broker loads.
In both cases, additional transaction fees are usually assessed, but pricing will largely depend on the size of your account, the size of the purchase and the pricing schedule associated with each brokerage firm. Clients of advisors who hold institutional accounts for their clients tend to benefit from lower trading costs, often as low as $9.95 per ETF purchase or $20 for mutual funds. Additional cost considerations should be given if you plan to use dollar-cost averaging to buy into the funds or ETFs, because frequent trading of ETFs could significantly increase commissions, offsetting the benefits resulting from lower fees.
Legal Structure of Funds
Both mutual funds and ETFs can vary in terms of their legal structure. Mutual funds can typically be broken down into two types.
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 the 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.
Mutual Funds Vs ETFs
Legal Structure of ETFs
An ETF will have one of three structures:
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 are also 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, unlike ETFs and closed-end mutual funds, 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 are paid directly to shareholders. Investors must trade in 100-share lots. Holding company depository receipts (HOLDRs) are one example of this type of ETF.
Tax Advantages and Disadvantages
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 how they are created and redeemed. 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.
Liquidity is usually measured by the daily trade volume, which is generally expressed as the number of shares traded per day. Thinly traded securities are illiquid and have higher spreads and volatility. When there is little interest and low trading volumes, the spread increases, causing the buyer to pay a price premium and forcing the seller into a price discount in order to get the security sold. ETFs, for the most part, are immune to this. ETF liquidity is not related to its daily trading volume, but rather to the liquidity of the stocks included in the index.
Broad-based index ETFs with significant assets and trading volume have liquidity. For narrow ETF categories, or even country-specific products that have relatively small amounts of assets and are thinly traded, ETF liquidity could dry up in severe market conditions, so you may wish to steer clear of ETFs that track thinly traded markets or have very few underlying securities or small market caps in the respective index.
A consideration before investing in ETFs is the potential that fund companies will go bust. As more product providers enter the marketplace, the financial health and longevity of the sponsor companies will play a greater role. Investors should not invest in ETFs of a company that is likely to disappear, thereby forcing an unplanned liquidation of the funds. The results for investors who hold such funds in their taxable accounts could be an unwelcome taxable event. Unfortunately, it is next to impossible to gauge the financial viability of a startup ETF company, as many are privately held. As such, you should limit your ETF investments to firmly established providers or market dominators to play it safe.
The Bottom Line
As products are rolled out, investors tend to benefit from increased choices and better variations of product and price competition among providers. It's important to note the differences between ETFs and mutual funds, and how those differences may impact your bottom line and investment processes.