Mutual Funds vs ETFs

Ever since ETFs or Exchange Traded Funds became popular, the debate about which kind of investment is better has continued to ensue. First of all, mutual funds need no introduction. These have been one of the most highly used investment mediums for any kind of investor because it offers broad diversification, professional management, and low investment minimums. Mutual funds are common in an investor’s portfolio ever since it made its debut in the 1920’s.

 

However, Exchange Traded Funds are catching up in popularity. Even though it was only introduced in 1993, many investors are beginning to realize the benefits that ETF’s can offer, and it is fast becoming the preferred investment tool for Wall Street and Main Street investors.   The question now is, which investment really is better? Mutual funds or ETF’s?  

 

Mutual Funds Vs ETFs: A Comparison of Features   Legal Structure

 

Mutual funds and ETFs have different legal structures. Mutual funds have two types. First is the open ended funds and second is the closed ended funds. Open ended funds are the most common in terms of volume and assets under management. With this type of fund, the purchase and sale of fund shares take place directly between the fund company and the investors. There is no limit towards how many shares are issued, if more investors choose to buy, then more shares are also offered. Price per share is usually dictated by federal regulations.

 

Closed end funds issue only a set number of shares and if the investor demand grows, new shares are no longer offered. Price shares are driven by investor demand.   ETFs on the other hand have three structures. The first is the Exchange Traded Unit Investment Trust which attempts to replicate specific indexes and limits investments in a single issue to 25% or less.

 

Second is the Exchange Traded Grantor which is very similar to a closed-ended fund, but with the difference that investors own underlying shares of the companies that the ETF is invested in. And third is the Exchange Traded Open-End Index Mutual Fund where dividends are reinvested during the day of receipt and only paid to shareholders in cash every quarter. Lending of securities is allowed, and derivatives may be used in the fund.  

 

Trading Process

 

When it comes to trading, ETFs offer greater flexibility as compared to mutual funds. In mutual funds, purchases and sales are made between the investors and the fund. The price of the fund is determined only at the end of the business day then the net asset value is determined. An ETF is redeemed and created in bigger lots by institutional investors and shares can be traded throughout a day, similar to a stock. ETFs may also be sold short which can be good to traders and speculators. Since ETFs are priced continuously in the market, there is a higher potential for trading and arbitrage because there is more fluctuation in prices.

 

Expenses

 

Shares of mutual funds that are actively traded and actively managed by a fund manager can results in higher management fees. Some ETFs may have lower expense ratios than similar conventional index mutual funds. However, note that most ETFs have expense ratios which are not dramatically lower than the lowest cost conventional index mutual funds with similar investment goals.

 

Tax Advantages and Disadvantages

 

ETFs offer better tax advantages to investors since they are passively managed portfolios. This means lesser capital gains than actively managed funds. ETFs are also more tax efficient than mutual funds because of how they are created and redeemed. ETFs only incur capital gains tax when the fund is sold. However, mutual funds will incur capital gains tax as shares within the fund are traded during the life of the investment.

 

Liquidity

 

The daily trade volume is usually the measure of liquidity. This is expressed in number of shares traded per day. Securities that are traded thinly are considered to be illiquid and have higher spreads and volatility. The spread increases when there is little interest and low trading volume. The buyer can be caused to pay a price premium and the seller can also be forced into a price discount in order for the security to be sold. When you purchase ETF’s you pay half the bid ask spread. Conventional no-load mutual funds do not have a bid/ask spread involved.  

 

Transferability

 

Complications can potentially arise when a managed portfolio is transferred to a different investment firm. This can happen with mutual funds because sometimes the fund positions have to be closed out before a transfer can occur. This can be troublesome for investors. Liquidating a portfolio’s mutual fund can increase risk because of trading at the wrong time, increase commission and fees, and incur early and unnecessary capital gains tax. With an ETF on the other hand, transfers can be done cleanly and simply when switching investment firms. ETFs are sometimes called as a portable investment.  

 

Advantages and Disadvantages

 

When choosing between an ETF and a mutual fund, it is also important to know some advantages and disadvantages of both investment types. ETFS generally offer better tax advantages, liquidity, and low ownership costs. It also has no minimum investment required since investors are limited only by the amount of money you have and the price per share. More options are also available. The drawbacks of ETFs is that they have more transaction costs, brokerage requirement, and dividend drag since dividends paid out by ETFs are not immediately reinvested.

 

Mutual funds have the advantage of no trading commissions for no-load mutual funds, dividend reinvestment, and no fuss pricing since fund price is ended at each trading day, giving little room for surprises. However, its drawbacks also includes high minimums, additional fees due to front and back end charges, and style drift because funds that aren’t tied to a specific index can be subjected to the whims of portfolio managers.

 

Ultimately there is no right or wrong answer when choosing between ETFs and mutual funds. However, there are many financial advisors who claim that ETFs hold more advantage than mutual funds. For those who are still choosing between the two investment types, it is essential to understand fully the pros and cons of each type and also to weigh which would be more suitable to your investment needs.  

 

Which investment vehicle do you prefer?

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  • Great article, informative for sure!

    I prefer a mix of ETFs and index mutual funds. I typically hold index mutual funds and ETFs that are income focused in my retirement accounts and growth focused funds in my brokerage accounts. But something to keep in mind is that buying mutual funds direct from Vanguard or another low-cost focused fund manager is pretty cheap, no brokerage fees and you can automate the buying process.

    • I forgot all about the brokerage houses allowing commission free trades of their own products. Good catch!

      I thought a person couldn't auto invest with ETF's. From my understanding that is only an advantage of mutual funds.

      For example if you wanted to invest 500 dollars on the 1st of every month. With an ETF wouldn't you have authorize the trades every time? Whereas with the mutual fund you can set and forget.

      • I am pretty sure you can automate the purchase of Vanguard ETFs in a Vanguard Brokerage account. But I need to double check that, I actually only have a mutual fund account there due to restrictions at work so I have not tried auto ETF purchases personally.

    • It's also important to be careful with timing and fee structures with MFs. Many brokerages have a 90-day waiting period for fee-free transaction-fee funds before you can sell them to cut off short selling.

  • Great overview of ETFs and mutual funds. I love the diversification both tools offer. As mutual funds have been around much longer, I'm more familiar with those but see the benefits offered by ETFs as well.

  • My broker also offer free transactions on ETFs so it's a plus. I also love the fact the EFT trades like regular stocks and you can go in and out as you please.

    • That is a huge benefit of ETF's. You don't have to wait to the end of the day to redeem shares. I'm curious what is your current ETF strategy?

  • I have mutual funds, stocks and ETFs. I particularly like the lower expenses of ETFs.

    • I noticed that as well. A equivalent ETF / Mutual fund. The ETF often has a lower expense ratio. I wonder why.

      • 2 things, basically:

        The first thing is that the ETF company does not have to manage cash for redemptions – the investor can sell the unit if they want to get out. With a Mutual Fund, the Mutual Fund company has to keep cash on hand to buy back the unit if the investor wants out.

        The second, and probably more important reason lies in how ETF units are created. Basically, when EFT units are created, the manager receives a bulk discount on investments, because they are only allowed to deal with select market participants who don't pay brokerage and can give them all the securities at the same time. The manager then only has to rebalance every now and again. With Mutual funds, the Manager pays significantly more because they have to purchase units in individual securities every time they receive cash from new investors or need to sell when cash is needed for redemptions to keep the Fund in line with their proportions suitable to their investment strategy.

        • So Kevin is it possible that an ETF which tracks the same index as a mutual fund will show closer correlation to that index since cash is not managed by the ETF. Effectively, having more money "in play" for longer?

          • Exactly! Cash balances do not track indexes very well.

            Cost advantages are probably the bigger contributor to ETFs having less tracking error, though. ("More money in play", as you say, because they can use the cash for investing rather than costs)

          • The cash account is the reason why many actively managed funds often lag the index as well… of course this in addition to the fund managers simply "picking wrong". Hmm so why do leveraged ETF's tend to get it wrong. For example, the 3x short ETF often do not pay 3x the return on market dips but definitely give you more than 3x the loss on market gains.

            Any theory behind this?

          • It is probably because of the assymetrical payoff of derivatives (the distribution and magnitude of upside potential and downside potential is not equal). To be able to provide enhanced returns the fund has to use derivatives of some sort to be able to stick with their mandate.

            In the case of a 3X short ETF I would guess that this happens because of the fact that prices can only go to zero on the downside, but can go up as much as it wants to (in theory) on the upside. Since they are betting against the direction, there is a limit to how far the index can go down (i.e zero), but unlimited losses when the index moves up. Hence, you are exposed to more than 3X the pain when the market moves against you and less than 3X, when the market moves the "right" direction (because you have to subtract your costs from your theoretical maximum profit)

          • That's a good explanation. Further research shows that it's the daily rebalancing often cause the leveraged ETF to be a bit off in returns / losses. With that said… if you hold them over 24hours you can be in some serious trouble.

        • A mutual fund is a basekt of stocks, bonds, options, or commodities that spreads your risk around so that you don’t lose all your money on one particular investment vehicle.The money is pooled together and a firm runs the fund. The upsides are that you don’t have just one stock that will break you. So diversification and professional management are your positives.The downside is that mutual funds are sorta slow to make money from. They go up very little over the year in my opinion. If you do want a fund, make sure it is a NO LOAD fund. Another downside is that if a mutual fund goes down in a year, it takes so much time for it to turn around and actually make you money. Check out the Vice Fund (VICEX). They invest in companies that sell vices, such as cigaretts, gambling, alcohol. An easier investment would be a Certificate of Deposit (CD) from a bank. They yield 6% a year right now. Go to your local bank and set one up. You’ll be glad you did because it is guaranteed money.

  • Mutual Funds vs ETFs | Your Finances Simplified…

    Ever since ETFs or Exchange Traded Funds became popular, the debate about which kind of investment is better has continued to ensue. First of all, mutual funds need no introduction. These have been one of the most highly used investment mediums for any…

  • […] mutual funds and exchange traded funds offer diversification by compiling a basket of stocks or other assets. Mutual funds allow the fund […]

  • Agreed! Holding them in the wrong 24 hour period can be leave you with serious buyer's remorse! 🙂

  • ETFs versus mutual funds really comes down to style. All of my taxable investments are in a brokerage account where I also invest in individual stocks. So the convenience factor for investing in ETFs come into play because they trade just like the stocks I own and can be co-mingled.

    The ETF world is crazy though, there are ETFs out there that are ridiculous. My personal favorite ETF is DIA, which mirrors the Dow Jones Industrial Average. It pays out dividends monthly which is unusual for that type of index tracking ETF.

    sfi

  • I prefer high yielding mutual funds, although I did have a phase of trading with ETF's.

  • […] The Roth IRA provides better control and management to your account compared to the traditional 401(k). Although both have a wide range of investment options, the Roth IRA allows you to choose the investment house you want to utilize; for the traditional 401(k), you will be locked in to your company’s management options. For the traditional 401(k), the default choice could oftentimes mean a poor choice. However, if the management option in your company is relatively good, then this shouldn’t be a problem. One other thing to note is that most 401(k) plans currently do not have ETFs as an investment option. There are some benefits to using ETFs over mutual funds. […]

  • […] mutual funds and exchange traded funds offer diversification by compiling a basket of stocks or other assets. Mutual funds allow the fund […]

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