Investors face a bewildering array of choices: stocks or bonds, domestic or foreign, different sectors and industries, value or growth. Deciding whether to buy a mutual fund or exchange-traded fund (ETF) may seem like a trivial consideration next to all the others, but there are key distinctions between the two types of funds that can affect how much money you make and how you make it. It’s useful, therefore, to understand the differences and how to turn them to your advantage.
Both mutual funds and ETFs hold portfolios of stocks and/or bonds and occasionally something more exotic, such as precious metals or commodities. They must adhere to the same regulations covering what they can own, how much can be concentrated in one or a few holdings, how much money they can borrow in relation to the portfolio size, and so on.
Beyond those elements, the paths diverge. Some of the differences may seem obscure and wonky, but they can make one type of fund or the other a better fit for your needs.
When you put money into a mutual fund, the transaction is with the company that manages it – the Vanguards, T. Rowe Prices, and BlackRocks of the world – either directly or through a brokerage firm. The purchase is executed at the net asset value of the fund based on its price when the market closes that day or the next if you place your order after the close of the markets.
When you sell your shares, the same process occurs in reverse. But don’t be in too great a hurry. Some mutual funds assess a penalty, sometimes 1% of the shares’ value, for selling early, typically sooner than 90 days after you bought in.
ETF investors don’t face that prospect. As the name suggests, ETFs trade on exchanges, just as common stocks do, and the other side of the trade is some other investor like you, not the fund manager. You can buy and sell at any point during a trading session at whatever the price is at the moment based on market conditions, not just at the end of the day, and there’s no minimum holding period. This is especially relevant in the case of ETFs tracking international assets, where the price of the asset hasn’t yet updated to reflect new information, but the US market’s valuation of it has. ETFs can reflect the new market reality faster than mutual funds can.
Another key difference is that most ETFs are index-tracking, meaning that they try to match the returns and price movements of an index, such as the S&P 500, by assembling a portfolio that matches the index constituents as closely as possible. Mutual funds can track indexes too, but most are actively managed; in that case, the people who run them pick holdings to try to beat the index that they judge their performance against.
That can get pricey. Actively managed funds must spend money on analysts, economic and industry research, company visits, and so on. That typically makes mutual funds more expensive to run – and for investors to own – than ETFs.
ETFs = Lower Costs, More Efficient
But passive management isn’t the only reason that ETFs are typically cheaper. Index-tracking ETFs have lower expenses than index-tracking mutual funds, and the handful of actively managed ETFs out there are cheaper than actively managed mutual funds.
Clearly, something else is going on. It relates to the mechanics of running the two kinds of funds and the relationships between funds and their shareholders.
Mutual funds and ETFs are both open-ended. That means that the number of outstanding shares can be adjusted up or down in response to supply and demand. How and why they do it aren’t the same, however.
When more money comes into and then goes out of a mutual fund on a given day, the managers have to alleviate the imbalance by putting the extra money to work in the markets. If there’s a net outflow, they have to sell some holdings if there’s insufficient spare cash in the portfolio.
In an ETF, because buyers and sellers are doing business with one another, the managers have far less to do. The ETF providers, however, want the price of the ETF (set by trades within the day) to hew as closely as possible to the net asset value of the index. To do this, they adjust the supply of shares by creating new shares or redeeming old shares. Price too high? ETF providers will create more supply to bring it back down. All of this can be executed with a computer program, untouched by human hands.
The ETF structure results in more tax efficiency, too. Investors in ETFs and mutual funds are taxed each year based on the gains and losses incurred within the portfolios, but ETFs engage in less internal trading, and less trading creates fewer taxable events (the creation and redemption mechanism of an ETF reduces the need for selling). So unless you invest through a 401(k) or other tax-favored vehicles, your mutual funds will distribute taxable gains to you, even if you simply held the shares. Meanwhile, with an all ETF portfolio, tax will generally be an issue only if and when you sell the shares.
Things to Consider When Switching
ETFs are relatively new, and mutual funds have been around for ages, so investors who aren’t just starting out are likely to hold mutual funds with built-in taxable gains. Selling those funds may trigger capital gains taxes, so it’s important to include this tax cost in the decision to move to an ETF.
The decision boils down to comparing the long-term benefit of switching to a better investment and paying more upfront tax, versus staying put in a portfolio of less optimal investments with higher expenses (that might also be a drain on your time, which is worth something). It’s also important to keep in mind that unless you gift or bequeath your portfolio, you will one day pay tax on these built-in gains. So you are often just deferring taxes not avoiding them.
Which Should You Use?
Given the distinctions between the two kinds of funds, which one is better for you? It depends. Each can fill certain needs. Mutual funds often make sense for investing in obscure niches, including stocks of smaller foreign companies and complex yet potentially rewarding areas like market-neutral or long/short equity funds that feature esoteric risk/reward profiles.
But in most situations and for most investors who want to keep things simple, ETFs, with their combination of low costs, ease of access, and emphasis on index tracking, may hold the edge. Their ability to provide exposure to various market segments in a straightforward way makes them useful tools if your priority is to accumulate long-term wealth with a balanced, broadly diversified portfolio. At the end of the day, both of these products are made available by most brokers.