Mutual funds have been very popular to invest in for the past few decades. Exchange traded funds, or ETFs, on the other hand, are relatively new but are gaining in popularity. As of 2013, global ETF assets were $2.25 trillion whereas mutual funds were at $15 trillion in the U.S. alone. Other than the sizes of the respective markets, mutual funds and ETFs have much in common, and can be equally risky or safe depending on what investments are contained within each. With so much in common they can be considered cousins with some differences.
Mutual funds and ETFs are investment products in which investors take ownership in a selection of investments. The differences lie within their structure, the way they are traded, and their expenses, taxes, and product types. A few differences are that ETFs can be bought and sold at any time during market hours like the shares of a stock, whereas mutual funds can only be purchased at the end of day after the price has been set. ETFs can be sold short, whereas mutual funds cannot, and typically ETFs have lower expense fees.
See also the 7 Questions to Ask When Buying a Mutual Fund
Let’s take a closer look.
Mutual funds can be broken down into two types:
- Open ended funds
Most mutual funds are open-ended funds. An open-ended fund issues more shares the more investors purchase the fund. Essentially there is no limit to the number of shares the fund can issue. Because there is a limitless supply of shares, the value of the investors’ shares is not affected by the number of shares.
- Close ended funds
In contrast to an open-ended fund, close-ended funds issue a limited number of shares available to the public. As such, the value of the fund is determined by the demand for the fund’s shares. The NAV, or net asset value, of the fund can be higher or lower than what the underlying value of the shares is worth.
ETFs on the other hand have three different types:
- Exchange-Traded Unit Investment
Securities are allowed and derivatives may be used in the fund; dividends are reinvested every quarter and paid out to shareholders in cash.
- Exchange-Traded Open-End Index Mutual Fund
Investments are limited in a single issue to 25% or less, and there are additional weighting limits for diversified and non-diversified funds.
- Exchange-Traded Grantor Trust
This is similar to a close-ended fund in that its configuration does not change despite the number of investors. Unlike closed-ended mutual funds and ETFs, the investor owns the underlying shares in the companies the ETF is invested in; dividends are paid out to shareholders directly.
Trading and Liquidity
ETFs can be traded just like a stock. Investors can short them, buy them on margin, and trade them throughout market hours. This characteristic allows an investor to place orders with a variety of limits or stop loss orders to get their desirable price.
With mutual funds, before a purchase can be made the net asset value must be calculated, which occurs at end of day. However, mutual funds settle after their trade date faster. Mutual funds take one day to settle, while ETFs take three days after the trade date to settle. Overall, ETFs have more trading flexibility, but the longer settlement date is something to take into consideration. Another aspect to take into consideration is that an ETF doesn’t require a minimum initial investment like many mutual funds require.
In regards to liquidity, ETFs can vary in how liquid they are. Broad-based index ETFs have more trading liquidity than narrow ETF categories like country-specific products. The more thinly traded the ETF, the higher the spread between the bid and ask price. When there is little interest and low trading volumes, the spread increases and the investor may have to pay a price premium to own it. Mutual funds, on the other hand, can be bought or sold without worrying about a spread or how liquid the market is, but again, it is only bought or sold at the end of day.
ETFs typically have lower fees than mutual funds due to their passive investment strategy nature. Expenses can range from 0.10% to 1.25% versus 0.20% for index funds to as high as 2%. The average mutual fund charges around 1.3% to 1.5%. Broken down, a mutual fund’s management expense ratio (MER) includes the cost of hiring the fund manager(s), the admin costs with running the fund, and brokerage commissions. ETFs have lower fees because they do without brokerage fees.
When purchasing or selling a mutual fund or ETF there can be trading commissions as well. Many mutual funds can be found without loads, also known as commissions, while ETFs can have trading commissions that can cost per trade unless a no-commission ETF is used.
With an ETF, an investor can determine when to sell and when to buy, timing their capital gains or loss. Because the decision lies with the investor just as it would with a stock, the tax consequences are within an investor’s control.
See also How Mutual Funds Are Taxed
With mutual funds, a fund manager can buy or sell securities at any given point in time to rebalance the fund, or in the case of a closed-end fund, to redeem an investor’s shares. The tax consequences are such that the investor will owe tax on any gains from these sales.
Six of the most popular ETFs are equity funds, fixed-income funds, commodity funds, currency funds, real estate funds and specialty funds. Mutual funds have the same product types except they can be even more niche, with the adoption of specific trading techniques, and can also be actively managed. Most ETFs are not actively managed and, because they are index based, they are inherently passive investments.
Why Mutual Funds Instead of ETFs?
While ETFs typically have lower fees, lower taxes and offer more flexibility versus a mutual fund, there are advantages to choosing a mutual fund over an ETF. With a mutual fund, an investor is getting a professional manager that is taking care of the fund. While some may or may not agree with the value added, investors should do their due diligence to make sure the manager is worth the expense.
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Mutual funds can also adopt an active investment management style that tries to beat the market index rather than match it. This would appeal to the more risky investor appetites. Further, mutual funds can adopt unique strategies that investors may find valuable.
Lastly, if an investor is making multiple investments with small amounts, the trading commissions on ETFs can add up per trade, whereas a mutual fund with no front or back load is essentially free to purchase up front. Either investment vehicle has the management expense associated with it.
The Bottom Line
It’s important to know the differences between mutual funds and ETFs before making any investment decision. Both have their pros and cons and attract different investors. ETFs are essentially purchasing a basket of stocks with trading commissions, while a mutual fund has a professional manager who has the option of adopting a passive style or more aggressive active management style and can use unique trading strategies. Whichever investment vehicle an investor prefers will depend on their risk tolerance and their investment objectives.