Mutual Funds Versus Exchange Traded Funds (ETFs)

Mutual Funds Versus Exchange Traded Funds (ETFs)

Most investors do not pick individual stocks and bonds. They pick managers who make these choices for them. The really wealthy use separate accounts managed “just for them” ( most “separate” accounts are managed pretty uniformly within an investment firm). The majority invest in commingled vehicles, alongside other investors with similar needs. The most popular commingled vehicles are mutual funds and exchange traded funds (ETFs).

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I

Definitions

A mutual fund is a pool of money collected from many investors to invest in securities like stocks, bonds, money market instruments, and other assets. Mutual funds are operated by professional money managers who allocate the fund’s assets and attempt to produce capital gains or income for the fund’s investors. A mutual fund’s portfolio is structured and maintained to match the investment objectives stated in its prospectus.

Mutual funds give small or individual investors access to professionally managed portfolios of equities, bonds, and other securities. Each shareholder participates proportionally in the gains or losses of the fund. Mutual funds invest in a vast number of securities, and performance is usually tracked as the change in the total market cap of the fund—derived by the aggregated performance of the underlying investments.

Most mutual funds are actively managed by a fund manager or team making decisions to buy and sell stocks or other securities within that fund in order to beat the market and help their investors profit. These funds usually come at a higher cost since they require a lot more time, effort, and manpower.

ETFs are very similar to mutual funds except most are passively managed to track a market or a market segment, and they trade like stocks. An ETF is called an exchange-traded fund since it’s traded on an exchange just like stocks. The price of an ETF’s shares will change throughout the trading day as the shares are bought and sold on the market. This is unlike mutual funds, which are not traded on an exchange, and trade only once per day after the markets close.

II

History

Most mutual funds are “open-end” which means their composition changes regularly, in contrast to “closed-end” funds with a constant composition.  

The first open-end mutual fund with redeemable shares was established on March 21, 1924, as the Massachusetts Investors Trust (it is still in existence today and is now managed by MFS Investment Management). In the United States, closed-end funds remained more popular than open-end funds throughout the 1920s, but today open-end funds are much more popular.

Seventy years later, on January 22, 1993, State Street Global Investors released the S&P 500 Trust ETF (called the SPDR or “spider” for short) It was very popular, and it is still one of the most actively-traded ETFs. Barclays entered the ETF business in 1996 and Vanguard began offering ETFs in 2001. As of the end of 2018, there were more than one hundred distinct issuers of ETFs.

Although the first American ETF launched in 1993, it took 15 more years to see the first actively-managed ETF reach the market. Most ETFs are passive.

Along the way, an interesting “competition” of sorts had started between ETFs and traditional mutual funds. 2003 marked the first year where ETF net inflows exceeded those of mutual funds. Since then, mutual fund inflows have typically exceeded ETF inflows during years where market returns are positive, but ETF net inflows tend to be larger in years where the major markets are weak. (For related reading, see 5 Reasons Why ETFs Work For Young Investors.)

The History and Future of Gold as an Investment

III

Regulation

Mutual funds and ETFs are regulated by the Securities and Exchange Commission (SEC) under the Investment Company Act of 1940 except on occasion where subsequent rules have modified their regulatory requirements. In response to The Great Depression Congress wrote into law the Securities Act of 1933 and the Securities Exchange Act of 1934 in order to regulate the securities industry in the interest of the public. 

Investment companies were still in their infancy in 1940. In order to instill investors’ confidence in these companies and to protect the public interest from this new type of security, Congress passed the Investment Company Act. The new law set separate standards by which investment companies should be regulated. The act defined and regulated investment companies, including mutual funds (which were virtually undefined prior to 1940).

IV

Trading

Purchases and sales of mutual funds take place directly between investors and the fund. The price of the fund is not determined until the end of the business day when net asset value (NAV) is determined.

ETFs trade like stocks. They are listed on exchanges and shares trade throughout the day just like ordinary stock. Unlike mutual funds, the market sets the price of an ETF so it trades in a bid-asked spread. If the price drifts too far away from the underlying value of the stocks in the fund (NAV), arbitrageurs step in to trade the ETF against Creation Units”which constitute the stocks the index that is being tracked. To facilitate and encourage this arbitrage, ETFs report their holdings daily. See “Disclosures” in the next section.

V

Disclosures

The Securities and Exchange Commission requires mutual funds to report complete lists of their holdings on a quarterly basis using SEC Forms N-Q and N-CSR.  These forms are accessible online at the SEC Edgar website. Also, many mutual funds disclose their holdings on their official websites.

Unlike mutual funds, SEC Rule 6c-11 requires daily reporting of ETF holdings. This provides the opportunity for arbitrage to keep prices in line.

VI

Taxes

Purchases and sales by mutual fund managers generate investment gains and losses as do dividend receipts. Shareholders receive form 1009 with their proportionate tax liability. Also, investor purchases and sales of mutual funds generate investment gains and losses.

By contrast, ETFs are more tax-efficient due to their construction and the way the IRS classifies them. Specifically, capital gain taxes are only realized on an ETF when the entire investment is sold whereas a mutual fund incurs capital gains taxes every time the assets in the fund are sold.

VII

Usage

According to the Investment Company Institute, there were 8,059 mutual funds with a total of $17.71 trillion in assets as of Dec. 2018. That’s compared to the ICI’s research on ETFs, which reported a total of 1,988 ETFs with $3.37 trillion in combined assets for the same period. For perspective, the US stock market of 5000 stocks is valued at $30 trillion.

From one fund in 1993, the ETF market grew to 102 funds by 2002, and nearly 1,000 by the end of 2009. According to research firm ETFGI, there are now at least 5,000 ETFs trading globally, with more than 2,000 based in the U.S. (If you include exchange-traded notes, a much smaller category, there is an additional 1,900 globally and another 270 in the U.S.).

VIII

Fees

A passive management style often results in lower expense ratios than those charged by actively managed funds. Some passive ETFs charge less than 0.05%, with some even charging 0.00%. That’s a sizeable advantage over actively managed funds that charge an average of 0.67%, according to Morningstar.

That said, some index mutual funds are now charging 0.00%, so an apples-to-apples comparison shows little difference in fees. 

What’s the Catch in Fidelity’s Zero-Fee Mutual Funds?

IX

Pros and cons of ETFs versus mutual funds

Pros

  • Access to many stocks across various industries
  • Low expense ratios and fewer broker commissions.
  • Risk management through diversification
  • ETFs exist that focus on targeted industries

Cons

  • Actively-managed ETFs have higher fees
  • Single industry focus ETFs limit diversification
  • Lack of liquidity hinders transactions
  • ETF Creation and Redemption is complicated
X

Target Date Funds

Model portfolios are ubiquitous. Most advisors use model portfolios consisting of mixes of mutual funds and ETFs. They are funds-of-funds. One of the most popular fund-of-funds in 401(k) plans is called a target-date fund (TDF). TDFs are invested aggressively when you’re young and gradually become more conservative as retirement approaches.

All target-date funds are mutual funds, and most consist primarily of other mutual funds. There was an attempt to provide TDF ETFs, but these attempts failed because 401(k) record-keeping systems are not set up to deal with vehicles that trade throughout the day. Blackrock shut down the last TDF ETF in October 2014, and there’s little sign that ETFs will ever again be provided as TDFs.

XI

Conclusion

Fees, taxes, and trading are the primary differentiators between ETFs and mutual funds. In exempt accounts like IRAs and 401(k)s, taxes, and trading are not the issues, leaving fees as the main consideration.  

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