ETFs vs Mutual Funds

by | Jan 31, 2023 | Research

The creation of the first modern mutual fund in 1924 revolutionized portfolio management by allowing investors to pool their resources and buy a mixture of stocks, bonds, or other investments. With this type of pooled investment, shareholders can share in the profits and losses of a basket of securities without having to own the underlying companies.

Then in 1987, Nate Most, a physicist, commodities trader, and former Navy submarine specialist, had an idea that modernized pooled investments. He conceptualized a collection of securities, similar to the holdings of a mutual fund, that traded like a stock. By 1993, he’d turned that idea into the first American Exchange Traded Fund [ETF].

Both ETFs and mutual funds seek to simplify the investing process by providing access to dozens or even hundreds of securities in a single investment. While ETFs and mutual funds have some similarities, they also have key differences that you should understand before deciding which to add to your portfolio.

ETFs are Typically Less Expensive than Mutual Funds

By assets, 94% of all ETFs are passively managed, meaning that the fund manager seeks to mirror an index rather than outperform it. Due to the lower effort needed to administer it, passive management is typically less expensive than active management. Mutual funds are much more likely than ETFs to be actively managed – or seek to outperform a particular benchmark – and therefore have the added costs of that management style.

The average expense ratio (the annual cost of an investment) for a passively managed equity ETF is 0.45%. On the other hand, the average expense ratio for a comparable mutual fund is 0.56%. When actively managed funds are added to the equation, the average expense ratio for all equity mutual funds increases to 1.13%.

In addition to higher expense ratios, mutual funds often have loads – otherwise known as sales charges. These vary by fund, investment amount, and length of holding, but can add up to 8.5% to the cost of a mutual fund. Loads are one of the most common hidden investment fees and investors often overlook them when choosing an investment.

Conversely, ETFs do not have loads. In addition to making ETFs a more affordable choice, many investors consider this price structure more transparent than mutual funds.

ETFs Do Not Have Minimum Investment Amounts

Mutual funds can have minimum investment thresholds, often combined with higher expenses, for those who invest smaller amounts. On the other hand, ETFs do not have set minimums; you can buy as little as one share – or even fractional shares in some cases. Additionally, the price per share and expense ratio are the same whether you buy one share of an ETF or one thousand shares.

ETFs Trade Throughout the Day, Mutual Funds are Priced Once Per Day

ETFs are priced throughout the day and traded like stocks. Conversely, mutual funds are priced and orders are executed only at market close. This means ETF shares can be bought and sold throughout the trading day while mutual funds cannot. The freedom to trade during the day can be particularly beneficial in volatile markets when a lot can change in a very short period of time.

For example, if you noticed a particular investment rapidly losing value and wanted to sell your positions at 10am, you could execute your order immediately with an ETF. With a mutual fund, you would have to wait until the close of trading for the day to execute your sale – which could lead to further losses.

Because mutual funds are priced only once at the end of each trading day, investors who buy or sell a mutual fund during the day do not know the exact price they will receive at the close of the market. This can lead to significant challenges for investors, especially those who are seeking to buy or sell at an advantageous price.

ETFs Have More Available Order Types Than Mutual Funds

Since ETFs trade like stocks, investors have a few order types to choose from. Some common types of orders include:

  • Market: An order to buy or sell at the current price.
  • Limit: Specifies a certain price or better an order must achieve.
  • Stop: Triggered when a stock or ETF reaches a certain price.
  • Good ‘til Cancel [GTC]: The order will remain active until you cancel it (typically up to 90 days).

These additional types of orders can help generate your desired outcome with less effort.

Some types of orders can help you buy at an advantageous price. For example, if ETF A is trading at $12 per share and you want to buy, but only at $10 or better, you could place a buy limit order, good ‘til cancel. If the ETF falls to your preferred level, you buy it automatically.

Different types of orders can also help you minimize losses. For example, if you own ETF B, currently trading at $25, and want to limit potential losses, you could place a sell stop order at $20, good ‘til cancel. If the price falls to $20, your order would be triggered, and you would sell at the first available price.

With mutual funds, there is only one type of order available – buy or sell at the closing price on any given day. To buy at an advantageous price, or sell to stem losses, you would have to monitor prices and place trades manually. Even then, you would not know which price you received until the market closed.

ETFs Are Typically More Tax Efficient Than Similar Mutual Funds

You are probably familiar with the concept of capital gains tax – the tax owed when you sell a security for a profit. However, you may not know that mutual funds and ETFs can also generate capital gains when the fund manager sells securities at a profit.

At the end of each year, a fund’s net capital gain is paid to investors as a special year-end “capital gains distribution.” These distributions are different than ordinary dividends and are taxed at long-term capital gains tax rates in non-retirement accounts. While both ETFs and mutual funds can pay capital gains distributions, the structure of ETFs helps to minimize these taxable distributions.

Mutual Funds Often Sell Securities to Meet Redemption Requests, Generating Capital Gains

Mutual fund shares are bought from and sold to the fund. Because of their structure, mutual fund managers must sell securities to meet redemption requests. This can result in many sales throughout the year and those sales can generate capital gains.

ETFs Typically Do Not Sell Securities to Meet Redemption Requests, Minimizing Capital Gains

ETFs are structured differently from mutual funds. Only Authorized Participants – typically large broker-dealers – can buy or sell shares from an ETF. When an Authorized Participant redeems ETF shares, the underlying securities are usually transferred rather than sold, so no capital gains are generated.

Individual investors buy and sell ETF shares on the secondary market. When this occurs, none of the underlying securities are affected and no fund-level capital gains are generated.

Because of their structure, ETFs do not have to sell securities to meet redemption requests which minimizes sales and resulting capital gains. However, both ETF and mutual fund managers rebalance and sell positions that no longer meet the objective of the fund. These activities can generate capital gains and lead to taxable distributions at year end.

ETFs vs Mutual Funds – Which is right for you?

The most advantageous type of investment for your portfolio depends on your personal situation, goals, and risk tolerance. Some investors favor the ease of investing in mutual funds, while others seek the flexibility and tax advantages of ETFs.

When deciding which type of investment to add to your portfolio, consider the costs and trading features of both ETFs and mutual funds. An experienced financial advisor can help you weigh the pros and cons of each investment type and choose the most appropriate option for your situation.

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