In today’s complex investing world and with the advancement in the discount online brokerage, many people have decided to take it upon themselves to do their own investing. However, there are many different alternatives available and choosing the most suitable investment can be a confusing task.
Two common types of investments are mutual funds and exchange-traded funds (ETFs). Both are great for novice and experienced investors alike because each type is comprised of a diversified basket of investments, such as stocks or bonds. This is a much easier option for the investor who doesn’t have the knowledge or the time to pick individual stocks. Index mutual funds and ETFs are great options for these investors. However, even though both are designed to do the same thing, they are very different from one another.
Traditionally, the biggest difference between mutual funds and ETFs was how each was managed. Mutual funds are mostly considered actively managed, in which a team of portfolio managers trades in order to perform better than a particular benchmark. ETFs, on the other hand, are considered passive investments and are designed to follow an index without any trading. However, in today’s fee-conscious environment, many mutual funds have been following suit with ETFs and offering index-based funds that work in a passive manner. To learn about actively and passively managed mutual funds, check out our article on the active versus passive debate.
The biggest difference between mutual funds and ETFs has always been the internal costs associated with running the investment, also known as the expense ratio. However, since index-based mutual funds have no active management, the costs have become close to its comparable ETF. For example, the Fidelity Total Market Index Premium Fund (FSTVX) has an expense ratio of 0.07%, which is only 2 basis points higher than the Vanguard Total Stock Market ETF (VTI) with an expense ratio of 0.05%.
One of the biggest reasons why mutual funds have a higher cost than ETFs is because of the need for indexes to constantly rebalance, which results in commission costs that coincide with bid-ask spreads. ETFs do not have this issue due to a process called creation and redemption-in-kind that avoids these costs. Another cost issue with mutual funds has to do with something called “cash drag.” Mutual funds are required to have a certain amount of cash to cover potential net redemptions. ETFs are not required to do this, due to the same creation and redemption-in-kind feature.
Lower fees are driving investors to passively managed funds. Our article on fund management fees explains the different fees investors pay to have their funds managed.
Most investors are really interested in which investment performs better when compared to its appropriate benchmark. In the table below, every ETF beat the comparable mutual fund over both the long term and the short term. This is mostly attributed to the lower expense ratio for the ETF. For example, the Vanguard 500 Index Fund (VFINX) has had a 10-year annual average of 7.12%. The SPDR S&P 500 ETF Trust has had a return of 7.15% for the exact same time period. The S&P 500, with no fees, had a 7.24% return to compare.
Another difference between mutual funds and ETFs is the taxation of the internal capital gains. When a mutual fund or an ETF is bought or sold, investors pay capital gains if it’s sold within a taxable account for a profit. Since mutual funds are traded to rebalance with an index, they incur capital gains with the stocks sold within the fund. This capital gain is passed on to the investor in the form of a distribution. For example, the Fidelity Small Cap Index Fund issues capital gains bi-annually, every June and December. On June 10, 2016, the fund distributed $0.085 in capital gains to its investors. ETFs do not have these internal capital gains like mutual funds, and are therefore more tax efficient. For more information on how mutual funds are taxed, click here.
Mutual fund prices are calculated according to the fund’s net asset value (NAV) on a daily basis and are priced at the end of the trading day. Mutual funds do not fluctuate during the day like a stock, with a moving stock price based on the bid-ask price. ETFs are traded on an intraday basis, and move up or down in price according to demand. ETFs are better options for investors that like to day trade or buy or sell using limit orders. If an investor wants to take advantage of a sudden market movement, ETFs will reflect the sudden change, whereas a mutual fund will not until after the market close.
The Bottom Line
In summary, index mutual funds and ETFs have the same purpose but with several distinguishable differences. In the end, ETFs have lower expense ratios over mutual funds due to the trading structure. With these lower costs, ETFs end up having better performances as a result.
To learn more about index funds, check out our Index Funds page.
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