Mutual Funds vs. ETFs: An Overview
Mutual funds and exchange-traded funds (ETFs) are both created from the concept of pooled fund investing, often adhering to a passive, indexed strategy that tries to track or replicate representative benchmark indices. Pooled funds bundle securities together to offer investors the benefit of a diversified portfolio. The pooled fund concept primarily offers diversification and comes with economies of scale, allowing managers to decrease transaction costs through large lot share transactions with pooled investment capital.
Key Takeaways
- Both mutual funds and ETFs offer investors pooled investment product options.
- Mutual funds have more complex structuring than ETFs with varying share classes and fees.
- ETFs typically appeal to investors because they track market indexes, mutual funds appeal because they offer a wide selection of actively managed funds.
- ETFs actively trade throughout the trading day while mutual fund trades close at the end of the trading day.
- Mutual funds are actively managed, and ETFs are passively managed investment options.
Understanding Mutual Funds
MFS Investment Management offered the first U.S. mutual fund in 1924. Since the 1920s mutual funds have been providing investors an extensive selection of pooled fund offerings. While some mutual funds are passively managed, many investors look to these securities for the added value they can offer in an actively managed strategy. For these investors, active management is the key differentiator as they rely on a professional manager to build an optimal portfolio rather than just following an index.
Mutual funds offer a wide variety of actively-managed fund options, while ETFs tend to have more passively-managed options.
Of the two options, as the leading, actively managed investment, mutual funds come with some added complexities. Typically, management fees will be higher for a mutual fund because managers are tasked with a more difficult job of identifying the best securities to fit the portfolio’s strategy. Mutual funds have also had long-standing integration into the full-service brokerage transaction process. This full-service offering is the primary reason for the structuring of share classes and also may add some additional fee considerations.
Mutual funds are created to be offered with multiple share classes. Each share class has its fee structuring that requires the investor to pay different types of sales loads to a broker. Different share classes also have varying types of operational fees. Many funds also allow for the automatic reinvesting of dividends.
The operational fees of a mutual fund are comprehensively expressed to the investor through the expense ratio. The expense ratio is made up of management fees, operational expenses, and 12b-1 fees. 12b-1 fees are a fundamental differentiator between mutual funds and ETFs. The mutual fund requires 12b-1 fees to support the costs associated with selling the fund through full-service brokerage relationships. The 12b-1 fees are not needed with ETFs, and therefore, can make the mutual fund expense ratio slightly higher.
It is also vital for an investor to understand the pricing of mutual funds. Mutual funds are priced based on a net asset value (NAV) which is calculated at the end of the trading day. Standard open-end mutual funds can only be bought and sold at their NAV which means an investor placing a trade during the trading day must wait until the final price is calculated to transact their order.
1924
The year the first mutual fund was offered to investors in the United States.
Understanding Exchange Traded Funds
The first ETF was introduced in 1993 to track the S&P 500 index, and their number grew to more than 3,400 ETFs by the end of 2017. Regulations primarily required these funds to be passively managed with securities tracking an index. In 2008, the Securities and Exchange Commission (SEC) streamlined its approval process for ETFs, which for the first time allowed for actively managed ETFs.
Historically, ETFs have been popular for index investors seeking to gain exposure to a particular market segment with the benefits of having diversification across the sector. In recent years, smart beta funds have become more popular, with assets growing nearly 20% annually for the past five years. Within the ETF offering arena, a smart beta ETF provides a type of customized index product built around a factor-based index methodology. This customization lets investors choose from index options with selected fundamental characteristics which, in many cases, can substantially outperform. With the evolution of smart beta index funds, ETF options have widened, giving investors a broader variety of passive ETF choices.
Fees are also an important consideration for ETF investors. ETFs do not carry sales load fees. Investors will pay a commission if required for trading them, but many ETFs trade for free. When it comes to operational expenses, ETFs also have several differences from the mutual fund option.
ETF expenses are usually lower for a few reasons. ETFs have lower management fees because many of them are passive funds which do not require stock analysis from the fund manager. Transaction fees are also typically lower as less trading is needed. As mentioned, ETFs also do not charge 12b-1 fees which decreases the overall expense ratio.
The pricing of ETFs also differs from mutual fund pricing. An important consideration when comparing the two. ETFs trade throughout the day on exchanges like a stock. This active trading can appeal to many investors who prefer real-time trading and transaction activity in their portfolio. Overall, the price of an ETF reflects the real-time pricing of the securities held within the portfolio.
Mutual fund fees are typically higher than those of ETFs, largely because the majority of mutual funds are actively-managed, which requires more labor hours and input than the more often passively-managed ETFs.
Similarities Between Mutual Funds and ETFs
Both types of investments are primarily regulated by the three principal securities laws enacted after the market crash of 1929. The three main laws are the Securities Act of 1933, the Securities and Exchange Act of 1934, and the Investment Company Act of 1940.
Both mutual funds and ETFs can be your go-to options for diversifying your investment portfolio. They work by pooling money from a bunch of investors and spreading it across different assets like stocks, bonds, or other securities. This diversification helps reduce the risk associated with individual investments since you’re naturally holding a range of assets within your single investment.
Another bit of good news is both types of funds offer liquidity. You can buy and sell shares in both, but how you do it differs (which we’ll talk about later in this article). Consider how the largest mutual fund, the Vanguard Total Stock Market Index Fund Admiral Shares (VTSAX), had total fund net assets as of September 2023 of $1.3 trillion. It is pretty easy to buy and sell most ETFs.
Differences Between Mutual Funds and ETFs
Mutual funds are like traditional investment clubs. They pool money from investors to buy a mix of stocks, bonds, or other assets, and they’re priced at the end of the trading day. One important thing to think about is you can only buy or sell mutual fund shares at that closing price. ETFs, on the other hand, are a bit more modern. They also pool investor money and invest in various assets, but they’re structured as tradable securities. This means you can buy and sell ETF shares throughout the trading day at market prices, just like you would with individual stocks.
When it comes to pricing, mutual funds are like ordering a meal at a restaurant. You buy or sell at the price set by the fund after they calculate the NAV at the end of the day. In contrast, ETF prices are like the stock market—they change in real-time based on supply and demand. This can lead to slight differences between the market price and the actual NAV, creating premiums or discounts that investors can capitalize on.
Mutual funds may come with various fees such as sales loads and management expenses. These are often expressed as an expense ratio and deducted from the fund’s assets. Some mutual funds have higher expense ratios compared to ETFs. ETFs typically have lower expense ratios and can be more tax-efficient because of the in-kind creation and redemption process. There are more specific tax considerations discussed in the following section, though the key takeaway here is ETFs are often cheaper because they are not actively managed.
Mutual funds provide a snapshot of their holdings periodically, usually every quarter. Unfortunately, there’s a time lag so this information isn’t always up to date. In contrast, ETFs are usually more transparent. They disclose their holdings on a daily basis, allowing investors to see exactly what assets the fund holds at any given moment. This transparency can be especially valuable for those who want to know precisely what’s in their portfolio at any specific time.
Special Considerations—Taxes
Taxes on mutual funds and ETFs are like any other investment where any income earned is taxed. Investors must pay either the short-term or long-term capital gains tax when selling their shares for a profit. Short-term capital gains apply to shares held less than one year before selling. Long-term taxes include the profit from shares sold after holding for a year or longer.
Short-term capital gains are taxed at the ordinary income tax rate. Long-term capital gains are taxed at 0%, 15%, and 20% depending on the investor’s ordinary income tax bracket. Investors in mutual funds and ETFs must also pay taxes on any dividends they receive from the holding. Ordinary dividends are taxed at the ordinary income tax rate. Qualified dividends are taxed at the long-term capital gains rate.
Mutual funds typically have higher tax implications because they pay investors capital gains distributions. These capital distributions paid out by the mutual fund are taxable. ETFs usually do not payout capital distributions, and therefore, can have a slight tax advantage.
For investors who hold their assets in a tax-advantaged vehicle like a 401(k), this advantage disappears. 401(k)s and other qualified plans take contributions on a tax-deferred basis. Money that is deposited—up to certain yearly limits—is not subject to any income tax. Further, the investments in the account can grow tax-free and do not incur taxes when trades are made.
Are Both Mutual Funds and ETFs Managed by Professionals?
Yes, both mutual funds and ETFs are managed by experienced professionals who make investment decisions on behalf of investors. These professionals have different goals which makes the decisions they make different for each type of investment.
Can You Hold Both Mutual Fund and ETF Shares in Your Investment Portfolio?
Absolutely, you can hold both mutual fund and ETF shares in your investment portfolio. They can coexist harmoniously, each offering its own strengths and attributes to your overall investment strategy.
How Does Pricing Vary Between Mutual Funds and ETFs?
Pricing for mutual funds is based on the end-of-day NAV price. ETF prices, on the other hand, dance around during the trading day, depending on supply and demand. This can lead to differences between market prices and NAV.
What Is the Key Difference in Timing When Trading Mutual Funds Versus ETFs?
Mutual fund trades occur at the end of the trading day, usually after the market closes, and you buy or sell at the NAV price set at that time. ETFs, on the other hand, allow you to trade throughout the trading day at market prices. This flexibility is a key difference in the infrastructure of how the fund works, though this level of flexibility may be utilized by active traders making moves throughout the day.
The Bottom Line
Investors have several ways to reap the benefits of diversification, and two of those ways are to invest in mutual funds or invest in ETFs. Mutual funds are priced once a day at the net asset value and traded after market hours, while ETFs are traded throughout the day on stock exchanges like individual stocks. Due to their more passive nature, ETFs often have lower expense ratios and are generally more tax-efficient.