Mutual Funds vs. Exchange Traded Funds
Stocks and bonds are key components of most investment portfolios. But for many investors, particularly those just starting to build their portfolios, it is often more economical and convenient to invest in pools of these securities instead of directly buying them. These pools are called funds. Two of the most widely used kinds of funds are Exchange-Traded Funds (ETFs) and open-end mutual funds.
Both kinds of funds typically provide diversified exposure to an asset class, sector, or investment strategy. For example, the Schwab U.S. Large Cap ETF (SCHX) provides broad exposure to the 750 largest U.S. stocks based on market cap. The Schwab International Index Fund (SWISX), another broadly diversified fund, holds 920 international companies based in Europe, Japan, and other parts of the world. By comparison, some funds provide narrow exposure to a specific investable area, such as the Technology Select Sector SPDR Fund (XLK), which is concentrated in the Information Technology sector.
Despite their similarities, ETFs and mutual funds differ in many ways. One example has to do with when and how they are priced. ETFs are priced continuously throughout the trading day. A mutual fund, on the other hand, is priced after the market closes based on the closing value of its underlying securities, resulting in a net asset value (NAV). This means that an ETF may trade at $50.00 a share at 10:00 A.M. and $50.05 at 2:00 P.M. based on the supply and demand for the ETF and its constituent holdings. In contrast, an investor would receive the same price for a mutual fund (the end-of-day NAV) regardless of whether they placed their trade at 10 A.M. or 2 P.M.
Settlement dates are another point to keep in mind. The settlement date is the day on which the trade is finalized. Mutual fund trades typically settle the day after the trade is placed, whereas ETFs typically settle in two days. This is particularly important to keep in mind when selling funds in order to make a withdrawal from an account. For example, if you were to sell a mutual fund on Monday, the cash would be available on Tuesday. If you were to sell an ETF on Monday, the cash would be available on Wednesday.
Like mutual funds, ETFs also have a net asset value. Unlike mutual funds, however, an ETF’s price may differ from its NAV. An ETF may trade at a premium to NAV if demand for the fund outweighs supply or a discount to NAV if supply outweighs demand. Premiums and discounts are often minimal in heavily traded funds, as arbitrageurs will root out and capitalize on any price inefficiencies.
ETFs and mutual funds also have different potential tax implications. Mutual funds often must sell securities to meet redemptions, which can result in capital gains. These gains must be passed through to mutual fund investors, and the timing and amount of such gains are not in the investor’s control. ETFs create and redeem shares using in-kind transactions that do not result in a tax bill.
Investment minimums differ as well. The minimum transaction quantity for an ETF is one share. The price per share may vary significantly from ETF to ETF, but the low cost of entry typically provides an advantage over mutual funds, which often have initial investment minimums in the thousands of dollars, with lower purchase minimums after that.
Costs are perhaps the biggest consideration when comparing ETFs and mutual funds. These days, most trading platforms charge no commission when an investor buys or sells ETF shares. This is not always the case for mutual funds, however. Mutual funds might be subject to transaction fees, including front or back-end sales charges, known as loads. In addition, though both ETFs and mutual funds charge management fees, known as expense ratios, the average management fee for ETFs is lower than the average management fee for mutual funds. This has to do, in part, with cost advantages inherent within the ETF structure. It is important to note, however, that not all ETFs have low management fees, and not all mutual funds have high management fees. It is possible to find ultra-low-cost mutual funds, and it is possible to find relatively expensive ETFs. Lastly, ETF investors must always be mindful of an ETF’s liquidity and its bid/ask spread. If an ETF is illiquid, meaning that its shares don’t have a lot of active buyers and sellers, then the bid/ask spread will be wider – which is, in essence, an extra trading cost.
According to ETF.com, 97% of U.S. ETF assets are passively managed. ETFs were originally created in the 1990s specifically as a vehicle for passive management, and today they remain heavily weighted towards passive strategies. Mutual fund assets, on the other hand, are more evenly split with approximately 45% passively managed and 55% actively managed. Passive funds attempt to track or replicate an index, like the S&P 500 for example, with minimal error. Active managers try to outperform an index by picking a subset of investments that they think will outperform. There is no guarantee that an active manager will outperform, however, and, in fact, most actively managed funds do not outperform their passive counterparts after accounting for fees. Active management is generally more costly than passive, as active managers devote significant resources to researching securities in order to choose the ones they believe will outperform.
To close, ETFs and mutual funds can be useful when building a diversified investment portfolio. Both have their strengths and weaknesses. ETFs are generally more tax-efficient and come with a lower cost, while mutual funds have faster trade settlement and often offer the potential for outperformance. One vehicle is not inherently better than the other, and an investor should always try to pick the right tool for the job – whether that tool is an ETF, a mutual fund, or something else.