One ongoing debate in the investment community has always been: Which is the better investment, mutual funds or exchange-traded funds (ETFs)?
A mutual fund is an investment vehicle funded by shareholders that trades in diversified holdings and is professionally managed. Mutual funds currently make up the largest portion of investment company assets with over $18.7 trillion in assets as of 2017.
Exchange-traded funds, or ETFs for short, are very similar to mutual funds in that they are a diversified portfolio of investments with professional management. ETFs were first introduced to the United States in 1993 and have been steadily growing in popularity, with currently $3.4 trillion in total assets as of 2017.
Investors should understand the differences between ETFs and mutual funds, as well as index ETFs and index mutual funds so that they can correctly assess the best way to help them achieve their goals.
Tracking an Index
ETFs gained popularity because many are based on an index and are considerably less expensive than a mutual fund. One of the largest ETFs in the world is the SPDR S&P 500 ETF (SPY), which is designed to track the S&P 500 Index. Since there is very little management involved in tracking an index, the fund has a very low expense ratio of 0.09% and is considered to be passively managed.
Conversely, mutual funds are typically actively managed with a professional money manager making trades throughout the course of the year. The manager’s goal is to not only outperform its peers but also to outperform its corresponding index, like the S&P 500. For instance, the American Funds Growth Fund of America (AGTHX) is designed to outperform the S&P 500. Over the last 10 years, the fund has averaged 8.48% and underperformed the S&P 500’s return of 9.14%. However, AGTHX outperformed in the three year at 11.07% versus 10.97% and the five year at 13.45% versus 12.98%.
In an effort to compete with ETFs, mutual funds have also been entering the passive management space and drastically lowering internal expense ratios. For instance, Vanguard has a mutual fund version of SPY called the Vanguard 500 Index Admiral (VFIAX). The fund is passively managed and is designed to track the S&P 500.
Differences in Fees and Sales Charge
One major difference between index mutual funds and ETFs tends to be the internal management fees, also known as expense ratios.
Typically, mutual funds are actively managed and thus involve higher expense ratios, averaging from 0.30% to over 2.00%. The Growth Fund of America listed above has an expense ratio of 0.64%, which is over seven times higher than the expense ratio in SPY. However, the Vanguard 500 Index Admiral fund, which is designed to mimic the S&P 500 just like SPY, actually has a lower expense ratio at 0.04%. Although the 0.05% difference might sound minimal, it actually affects performance. Over the trailing five years, VFIAX has outperformed SPY with 12.94% versus 12.85%. VFIAX has also outperformed in almost every timeframe except during the last one month.
Another major difference between mutual funds and ETFs is the sales charge or commission costs. ETFs trade like a stock and will usually incur a commission when bought or sold. There is also no minimum to buy or sell ETF shares.
Mutual funds, on the other hand, have a more complex situation, depending on the share class. The A share class of a mutual fund usually has an upfront load, ranging from 2.00% to 6.00%. There is also a C share that has a 1.00% upfront fee and a higher expense ratio since the charge is considered a level-load. The Growth Fund of America A share has a starting upfront sales charge of 5.75%. The Vanguard VFIAX does not have an upfront sales charge but has a minimum purchase of $10,000. Vanguard does offer the same fund, called the Vanguard 500 Index Investor Share (VFINX), at a lower minimum of $3,000, but then the expense ratio is 0.14% instead of 0.04%.
Difference in Structure and Taxation
A key difference between index mutual funds and ETFs is the structure and taxation of each. Mutual funds are purchased and redeemed based on the net asset value of the fund and only trade once a day at 4:00 pm ET. One of the benefits of an ETF is that they can be bought and sold intraday, just like a stock.
One benefit that ETFs have over mutual funds is the taxation. Both ETFs and mutual funds are subject to capital gains and losses, depending on the holding period when they are bought or sold. However, mutual funds carry an additional tax for their shareholders in the form of capital gain distributions. Mutual funds are required to pass on their capital gains to shareholders at least once a year.
The Growth Fund of America, for example, issued its shareholders a long-term capital gain of $3.23 per share on December 20, 2017. This distribution is equal to 6.5% of the fund’s total NAV. However, index funds tend to have much smaller or no capital gains distributions since there is very little trading in the underlying fund. As a result, a fund like the VFIAX has not had a capital gain distribution since 1999.
Trends in Mutual Funds and ETFs
Since mutual funds have been around considerably longer than ETFs, there are many more varieties with choices in equity, bond, international, commodity or even alternative investments. Equities are the most popular mutual fund variety, with 55% currently making up the market share of total mutual funds. Next is bonds with 22%, money market funds with 15% and finally hybrid funds at 8%.
Index mutual funds have been a focus of large growth in the mutual fund world, as index funds have grown from representing 9% of total funds in 2007 to 18% in 2017. Equity mutual funds had a total market share of 13.6% of all mutual fund assets in 2008. As of the end of 2017, equity mutual funds now represent 26.6% of all mutual fund assets. One of the main reasons why mutual funds continue to maintain popularity over ETFs is that mutual funds are typically the investments available within an employer-sponsored retirement plan, such as a 401(k). Of all U.S. households that own mutual funds, 64% own mutual funds within an employer-sponsored retirement plan.
If you are wondering whether mutual funds are right for you at all, you should read why mutual funds, in general, should be a part of your portfolio.
ETFs have been exponentially growing in popularity, as there were 728 ETFs in 2008 and now the number is close to 2,000. In fact, 2017 was a record year for issuance of new ETFs with 471 new issues coming to the marketplace. When compared to mutual funds, ETFs have a much higher concentration in equities, with over 81% of total assets. Most ETFs are invested in large-cap domestic equities, which currently make up 27%. Bonds and hybrids make up only 16% while commodities make up 2%. Bond ETFs are significantly less popular because bond investors typically use a bond index as a benchmark, but rarely invest in a bond index. Equity ETFs can mirror the comparable stock index with relative ease. Bond indexes are comprised of thousands of different bonds, which can be very cumbersome and expensive for most individual ETFs.
Since both index mutual funds and ETFs are designed to track a particular index, the performance should be relatively close to the index. Expenses are the number one reason why an index fund or ETF might be underperforming the corresponding index.
However, another useful measure for investors is to use the tracking error, a measure to track exactly how a fund’s performance compares to the index; the smaller the tracking error, the better.
Be sure to check our News section to keep track of recent fund performances.
Investors will find plenty of reasons why they should use an index fund or ETF. Index funds and ETFs offer great diversification for a very lower cost, which is great for almost every investor. In fact, many believe that index funds beat the majority of actively managed funds over the long haul.
Mutual index funds and ETFs are also great ways for an investor with a smaller initial purchase amount. Mutual funds can be started with as little as $100 and ETFs can be purchased one share at a time. Purchasing one of these is a much more risk-averse investment that is diversified among many holdings, instead of purchasing one stock with the same amount of money.
ETFs can also be used in taxable accounts since they are much more tax efficient than mutual funds. An investor in a high income tax bracket will only be taxed when the ETF is bought, sold or issues a dividend, unlike a mutual fund that could potentially issue a capital gain distribution.
The Bottom Line
Overall, both index mutual funds and ETFs have a variety of differences. When deciding on the best option, investors should examine the fund’s expense ratio, trading costs, structure, past performance and tracking error. If the funds are to be used in a taxable account, then capital gain distributions might be a factor and an ETF might be the right solution.
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