Two of the most popular investment vehicles today are mutual funds and exchange-traded funds (ETFs), and it’s easy to see why both attract so much attention. To the average investor, mutual funds and ETFs can look nearly identical, yet their inner workings differ in important ways. Understanding how they’re built, how they’re managed, and how you buy or sell them can help you make smarter choices. Before investing, it’s worth understanding how each option works and which one best suits your financial goals.
Mutual Funds and ETFs – Similarities
Mutual funds and ETFs are known as “passive investment vehicles.” That’s because they each try to track or replicate benchmark stock indexes such as the S&P 500. Some might track stocks in a specific economic sector instead, like technology, mining, or energy. In most cases, investors do not have to actively manage a mutual fund or ETF.
Most mutual funds are managed by a professional at a bank or investment firm. Mutual funds and ETFs are also known as “pooled investments.” As that label implies, they take money from many different investors (usually hundreds or thousands of people) and pool it together. Pooled investment funds offer diversification and economies of scale.
Mutual funds and ETFs can invest their pooled money in thousands of individual stocks. Both investments are regulated by the exact same securities laws. For these reasons, it’s understandable that many people wrongly assume that mutual funds and ETFs are basically the same. While they each take a similar approach to investing, the reality is that there are distinct differences between the two. Which investment type is best for you will depend on your individual circumstances and appetite for risk.
Benefits of Mutual Funds
The first mutual fund in the United States was offered in 1924 during the bull run that preceded the Great Depression. Since then, mutual funds have provided investors with a massive selection of pooled fund options. While some mutual funds are passively managed, the vast majority are actively managed by a professional manager. Their full-time job is to build a profitable portfolio for their clients. They carefully pick various stocks to invest in. It’s not as easy as simply tracking or replicating a stock index like the NASDAQ.
Mutual funds are great if you don’t feel confident managing your own investments. If you have little knowledge or experience with picking stocks by yourself, a mutual fund is a good choice. Let a professional do it for you. Not only that, but your money will work in partnership with the investment of others. You might not be able to afford 100 shares of Tesla on your own, for example. But your mutual fund certainly can.
Downside of Mutual Funds
Mutual funds tend to be more complex than ETFs. They are also more expensive. Mutual funds have management fees that are typically much higher than the fees associated with ETFs. The mutual fund fees, usually called the “Management Expense Ratio” (MER), are used to pay the fund manager and their institution. Basically, it’s the service fee you pay to have an expert manage your investments on your behalf.
Mutual funds are also structured in multiple share classes. Each share class has its own fee that might require you to pay different types of sales loads to a broker. There can also be operational fees charged with mutual funds. All of the various fees are rolled together and expressed as the MER. It’s typically charged as a percentage of the return or profit on the mutual fund. That means the better your investments do, the more it costs you. The fees do not typically come out of the principal amount invested.
Another important difference to note is that mutual funds are priced based on a Net Asset Value (NAV) that is calculated at the end of each trading day. Standard mutual funds can only be bought and sold at their NAV price. That means that investors placing a trade during the trading day must wait until the final price is calculated for the trade to actually be executed.
ETF Explained
Exchange-traded funds are a much newer investment product than mutual funds. The first ETF was created in the mid-1970s by investor John Bogle, who founded and was CEO of The Vanguard Group. That company remains one of the largest issuers of ETFs in the world today. The first widely available ETF was introduced in 1993 to track the S&P 500 Index. At the start of 2018, there were more than 3,400 ETFs available to investors. By 2019, more money flowed into ETFs than mutual funds for the very first time. That signaled a shift in popularity towards ETFs among investors.
ETFs are the most passive investment you can own. By that, we mean they are not managed by an individual investor or a professional manager. An ETF simply replicates the stocks of a particular index, such as the S&P 500. As the stock index goes, so goes the ETF. If the stock index rises, the ETF rises. If the index declines in value, the ETF declines as well. Where a mutual fund manager tries to beat the performance of a benchmark index, an ETF simply tries to match the performance.
Benefits of ETFs
The main benefits of ETFs are that they offer exposure to markets and diversification at a fraction of the cost of a more actively managed mutual fund. They don’t carry sales load fees either. You will pay a commission (if required) for trading an ETF, but it’s also possible to avoid that. Many ETFs trade for free through online or electronic brokers. When it comes to operational expenses, ETFs also tend to be cheaper. They offer lower management fees since they are passive funds. In short, you’re not paying someone to analyze an ETF on a daily basis to ensure maximum return. Transaction fees are also typically lower, since less trading is needed.
The pricing of ETFs is often much different than mutual funds. ETFs trade throughout the day just like a stock. This active trading can appeal to many investors who prefer real-time trading and transaction activity. Investors do not have to wait until the end of the trading day to execute a transaction with an ETF, unlike a mutual fund.
Performance/Return On Investment
Over the long term, very few fund managers beat the stock market. For this reason, it may be more advantageous to invest in an ETF than a mutual fund. Consider that the S&P 500, comprised of the 500 largest U.S. companies, has provided an average annualized return of 9.96% since 1990.
By comparison, most mutual funds advertise annual returns of between 2.5% and 5%. When it comes to long-term performance and return on investment, it’s hard to beat an ETF. Given the unpredictable nature of stocks and the ups and downs of the stock market, it’s very difficult for even skilled mutual fund managers to post better returns than you could get from using your money to track the markets directly.
Tax Implications
When it comes to taxes, mutual funds and ETFs are largely treated the same by the government. Unless either investment vehicle is held in a tax-sheltered or tax-deferred account, such as a 401(k) or RRSP, then you’ll be taxed on any capital gains and dividends you receive. Investments in a 401(k), IRA, or RRSP can grow tax-free and do not incur taxes when trades are made.
That said, mutual funds tend to have higher tax implications. This is simply because they pay their investors capital gains distributions. These capital distributions are taxable regardless of whether they are held in a tax-deferred account or not. ETFs usually do not pay out capital distributions. Therefore, they have a slight tax advantage over mutual funds.
The Bottom Line
When you consider the costs, performance, and tax implications of both products, ETFs appear to be the better choice. However, mutual funds may still appeal if you want your money managed by a professional. If you don’t want to be bothered with tracking the performance of the stock market yourself, then a mutual fund may make sense.
Just read the quarterly statement they send you and ensure your money is growing to your satisfaction. However, if you’re focused on maximizing your returns, keeping fees low, and paying less tax, then ETFs are the clear choice as an investment vehicle.
