Stocks, ETFs, Mutual Funds, Closed-End Funds….there are so many vehicles you can choose when it comes to investing. As we’ve advised many clients over the past few years, many clients will often want to understand the difference between ETFs (Exchange Traded Funds) and Mutual Funds. Below, we highlight four key differences between the two.
- Fees: ETFs on average have lower expenses than a similar mutual fund because there are no sales commission front-ended or back-ended loads and the operating expenses are often lower. Take for example different expense ratios for funds which each hold the S&P 500: IVV 0.08%, MSPIX 0.35% and SBSPX 0.59%. The Financial Industry Regulatory Authority (FINRA) has a great tool you can use to compare and analyze different funds: http://apps.finra.org/fundanalyzer/1/fa.aspx
- Tax Efficiency: Holding an ETF in a taxable account will create less tax liabilities than holding a similar mutual fund. Why? Because there are fewer “taxable events” in the conventional ETF structure. Mutual fund managers constantly rebalance funds by selling securities to accommodate shareholder redemptions or to re-allocate. These sales create capital gains for shareholders even those who have an unrealized loss on the overall mutual fund. In contrast, ETFs create or redeem “units” which are baskets of assets which approximate the entire ETF exposure which means the investor is usually not exposed to capital gains on any individual security of the underlying structure.
- Trading: ETFs are bought and sold like stocks on exchanges from the opening bell until the closing bell. There is a bid price from the buyers and an ask price from the sellers. The spread between the highest buy price and the lowest sell price can vary based on the trading volume, just like stocks. Mutual fund orders are executed at the end of each day and redeemed directly by the mutual fund company itself based on the net asset value (NAV) of the fund. The NAV is calculated daily and each day this is the price at which an investor must buy or sell the fund. While ETFs have a NAV, the price is set by the supply and demand of the market buyers and sellers which means ETFs can trade at a premium or discount to their NAV.
- Passive vs. Active Management: ETFs predominately use passive strategies or indexing which means portfolio managers don’t make decisions about what securities to buy and sell. The goal is to replicate the performance of the index as closely as possible. Whereas the majority of mutual funds employ active management in an attempt to outperform the market or a particular benchmark. Unfortunately, there are multiple studies that show that actively managed mutual funds underperform their benchmark more than 60% of the time in the past 10 years and statistically get worse over more extended periods.