Saturday, November 23, 2024
Trying to decide between mutual funds or ETFs for your investment portfolio? Confused about the differences? With so much noise and so little signal, it can be hard to know which one is right for you. In this post, we discuss the key differences between mutual funds and ETFs and help you make an informed decision, one that best suits your needs as a DIY investor. We'll also provide a detailed analysis of the advantages and disadvantages of each.
So, whether you're an old pro, new to investing, or just want further insight into this debate, here's everything an investor needs to pick a winner in the heavyweight match between mutual funds and ETFs.
Mutual funds and Exchange-Traded Funds (ETFs) are both investment vehicles that let investors pool their money to purchase a variety of securities. Both mutual funds and ETFs generally have “sponsors.” That is an organization that both markets the fund to potential investors and earns a fee from managing it.
While there are many passively managed or “index funds,” many mutual funds are actively managed, meaning a manager, hired by the fund, using his judgment, buys and sells securities in an attempt to produce returns for fund shareholders. In contrast, and although there are exceptions, ETFs are typically passively managed portfolios that track a pre-determined index or asset class.
As a class, ETFs tend to offer lower expenses compared to mutual funds. According to the Investment Company Institute, the average expense ratio for equity mutual funds is roughly 0.60% of assets. For ETFs, the ratio falls to 0.45%, a small but not insignificant difference.
ETFs also tend to be more tax efficient, a fact we will discuss in detail below. First, a bit of history.
Mutual funds date back to the 1920s when the very first mutual fund, the Massachusetts Investor’s Trust (MIT) was established. MIT did then what mutual funds do to this day, enabling investors to pool their funds, hire a professional manager and diversify their portfolios. In 1940, the U.S. Congress passed the Investment Company Act which regulates all mutual funds and has set up guidelines for how they must operate.
ETFs, on the other hand, are a relatively recent innovation that first emerged in 1993. ETFs trade like stocks, which means that investors can buy and sell their shares throughout the day. Unlike mutual funds, ETFs also allow investors to take advantage of stop and limit orders, short selling, and leveraged trading.
The concept of ETFs emerged in response to the 1987 stock market crash. Investors then were seeking, and fund sponsors were eager to offer, alternatives to traditional mutual funds that could provide, among other things, intra-day liquidity. In the early 1990s, several financial industry leaders began developing the idea of an investment fund that could be traded on stock exchanges like individual shares.
The first ETF was launched in the United States on January 22, 1993, by State Street Global Advisors. The fund, known as the Standard & Poor's Depository Receipts (SPDR), or "Spider," tracked the S&P 500 Index (ticker symbol: SPY). It allowed investors to gain exposure to a broad market index with a single trade, providing instant diversification and, because it could be bought and sold during the day, using stop and limit orders, increased flexibility compared to traditional mutual funds.
The success of the SPDR ETF led to the introduction of additional index-tracking ETFs, such as the Nasdaq-100 Index Tracking Stock (QQQ) in 1999 and the iShares Russell 2000 ETF (IWM) in 2000. As the popularity of ETFs grew, so did the variety of offerings. Sector-specific, international, and fixed-income ETFs have been introduced, catering to different investor preferences and risk tolerances.
At the time of the first ETF's launch, the legal framework in the United States did not specifically accommodate ETFs. However, the Securities and Exchange Commission (SEC) granted exemptive relief to State Street Global Advisors under the Investment Company Act of 1940, allowing them to operate an open-end investment company with unique features, such as intra-day trading and the creation/redemption process involving authorized participants. The concept of Authorized Participants is central to our story and something we discuss in detail below.
Over time, the SEC continued to grant exemptive relief to other ETF issuers, enabling the growth of the industry. Finally, in September 2019, a full sixteen years after the introduction of the first ETF, the SEC adopted Rule 6c-11 under the Investment Company Act of 1940, which modernized the regulatory framework for ETFs, streamlining the process for launching new funds and enhancing transparency for investors.
While Mutual Funds and ETFs both have their advantages and disadvantages, the tax implications of ETF ownership are substantial.
Taxes on both mutual funds and ETFs are determined by the type of income generated from the underlying investments. Mutual fund dividends and capital gains are passed out to shareholders. Mutual fund shareholders then pay taxes on these gains: dividends at ordinary income rates while capital gains are taxed at a lower rate. ETFs, however, can be subject to special taxation rules depending on the type of security held within the ETF and whether or not it is actively traded. Generally, ETFs have more favorable tax treatments than mutual funds, as long-term capital gains may be eligible for preferential tax rates. Investors need to understand the tax implications of any investment before deciding to invest.
When a mutual fund manager sells securities within the portfolio, the fund may realize capital gains on that transaction, even if the proceeds of that sale are immediately invested in other securities. These gains must be distributed to shareholders at least annually, and shareholders are required to pay taxes on these distributions, even if they then reinvest the gains. This can create a tax liability for investors, regardless of whether they sold any shares of the fund. It can also create so-called “phantom gains” when a fund sells securities at a gain during a year in which it has a net loss.
ETFs have a unique creation and redemption process involving Authorized Participants (APs), which allows them to avoid triggering capital gains when trading underlying securities. When an ETF needs to sell a security, it can do so through an in-kind exchange with an AP, meaning the ETF transfers the security to the AP instead of selling it. This process enables ETFs to minimize capital gains distributions, making them more tax-efficient than mutual funds.
Dividends earned by both mutual funds and ETFs receive identical tax treatment. Dividends received from the underlying securities held by both mutual funds and ETFs are typically passed on to the shareholders. These dividend distributions are taxable, typically at ordinary income tax rates.
The primary responsibility of an Authorized Participant is to facilitate the creation and redemption of ETF shares, ensuring liquidity and maintaining the ETF's market price close to its net asset value (NAV).
When there is increased demand for ETF shares in the market, the AP can create new ETF shares by assembling a basket of securities that mirrors the ETF's underlying portfolio. This basket is then delivered to the ETF issuer in exchange for a proportional number of ETF shares. The AP then sells these newly created ETF shares in the secondary market to investors.
Conversely, when there is decreased demand for ETF shares, the AP can buy ETF shares from the market and return them to the ETF issuer. In exchange, the AP receives a basket of securities that replicates the ETF's underlying composition. The AP can then sell these securities in the market.
A key aspect of the AP's role in ETFs is the ability to conduct in-kind transactions. When creating or redeeming ETF shares, the AP exchanges securities rather than cash, which minimizes the need for the ETF to sell securities and realize capital gains. As a result, ETFs are generally more tax-efficient than mutual funds, as they can avoid triggering taxable events through this in-kind exchange process.
Authorized Participants also help maintain the price stability of ETF shares by taking advantage of arbitrage opportunities. If the market price of an ETF deviates significantly from its NAV, the AP can buy or sell ETF shares to correct this discrepancy. For example, if the market price is higher than the NAV, the AP can create new ETF shares and sell them in the market, increasing supply and driving the price down. Conversely, if the market price is lower than the NAV, the AP can buy ETF shares, decreasing supply and driving the price up. This arbitrage mechanism helps keep the ETF's market price in line with its underlying value.
Participants are essential players in the ETF ecosystem, ensuring liquidity, maintaining price stability, and contributing to the tax efficiency of ETFs. Their role in the creation and redemption process enables ETFs to function effectively and provide investors with a flexible and cost-effective investment option.
Despite the significant growth of exchange-traded funds (ETFs) in recent years, mutual funds continue to attract a substantial amount of investment capital. This analysis explores the advantages of mutual funds over ETFs, differences in investment strategies, and various features that make each option suitable for different types of investors. Key variables, such as fees, diversification, liquidity, and transparency, will also be discussed in terms of their impact on investors' decision-making processes.
Active Management: One of the reasons some investors prefer mutual funds is that they prefer active management. Actively managed mutual funds employ portfolio managers who use their expertise and research to select securities to outperform a benchmark index. In contrast, many ETFs are passively managed, tracking an index without attempting to outperform it. Investors who believe in the value of active management may choose mutual funds in pursuit of higher returns.
Automatic Investment and Reinvestment: Mutual funds allow investors to set up automatic investment plans, making it easy to contribute to their investments regularly. Additionally, mutual funds often provide the option to automatically reinvest dividends and capital gains distributions, enabling investors to compound their returns over time. While some ETFs offer similar features through brokerage platforms, these options may not be as widely available or convenient as those offered by mutual funds.
Automatic Rebalancing: Automatic rebalancing plans are offered by virtually all mutual fund company is a service that helps investors maintain their desired asset allocation over time. Asset allocation refers to the distribution of investments across different asset classes, such as stocks, bonds, and cash, based on an investor's risk tolerance and investment objectives.
With an automatic rebalancing plan, the mutual fund company periodically reviews and adjusts the portfolio holdings to bring them back in line with the target asset allocation. This ensures that the investor's investment mix stays on track and aligns with their intended risk profile and is an extremely important and often overlooked part of a successful investment plan.
Many brokerage accounts, where ETFs are held, also offer rebalancing plans but not all and the assets that can be held in those accounts do not lend themselves as much to periodic rebalancing.
Automatic Redemption Plans: An automatic redemption plan, also known as an automatic withdrawal plan or systematic withdrawal plan (SWP), is a service offered by mutual fund companies that allow investors to receive regular payments from their mutual fund investment.
With an automatic redemption plan, investors can set up a predetermined schedule to receive a specific amount of money from their mutual fund at regular intervals. These payments can be made monthly, quarterly, or annually, depending on the investor's preference.
Again, these plans, crucial to making the best use of your investment assets in retirement, are offered by brokerage accounts but, for a number of reasons, ETFs and similar assets are not as well suited for these types of plans.
No Bid-Ask Spread: When trading ETFs, investors must consider the bid-ask spread, which is the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept.
When buying an ETF, you typically pay the ask price, which is the higher of the two prices. This is the price at which a seller is willing to sell their shares. The ask price represents the cost you would pay to purchase shares of the ETF from the market.
When selling an ETF, you typically receive the bid price, which is, conversely, the lower of the two prices. This is the price at which the buyer is willing to buy shares from you. The bid price represents the amount you would receive when selling your shares in the market.
This spread can increase the cost of trading ETFs, especially for less liquid ETFs. In general, highly liquid and widely traded ETFs tend to have smaller bid/ask spreads, typically just a few cents or fractions of a cent. On the other hand, less liquid or more niche ETFs may have wider bid/ask spreads, which could be a few cents or more. In contrast, mutual fund transactions occur at the net asset value (NAV) calculated at the end of the trading day, with no bid-ask spread.
Fractional Shares: Mutual funds allow investors to buy fractional shares, making it easier for them to invest a specific dollar amount and fully utilize their investment capital. While some brokerage platforms now offer fractional shares for ETFs, this feature may not be universally accessible.
The choice between mutual funds and ETFs often depends on the investor's preferences, goals, and investment strategies. Some key differences include:
Active vs. Passive Management: As mentioned earlier, mutual funds are more likely to be actively managed, while ETFs are typically passively managed. Investors seeking active management may prefer mutual funds, while those who believe in the efficiency of passive investing may opt for ETFs.
Cost Considerations: ETFs generally have lower expense ratios than mutual funds due to their passive management style and lower operational costs. However, when trading ETFs, investors may incur additional costs, such as bid-ask spreads and brokerage commissions. Mutual fund fees can vary widely, with some low-cost index funds offering expense ratios comparable to ETFs.
Tax Efficiency: ETFs are generally more tax-efficient than mutual funds due to their unique creation and redemption process involving authorized participants. This process minimizes capital gains distributions, which can result in a lower tax burden for investors holding ETFs in taxable accounts.
Trading Flexibility: ETFs trade like individual stocks on stock exchanges, providing intra-day liquidity and price transparency. This flexibility allows investors to execute various trading strategies, such as limit orders, stop orders, and short selling. Mutual funds, on the other hand, are bought and sold at the end-of-day NAV, limiting intra-day trading opportunities.
The choice between mutual funds and ETFs can have significant implications for investment outcomes, depending on factors such as management style, fees, tax efficiency, and trading flexibility. Each investor's unique circumstances, preferences, and goals will determine which option is most suitable for their needs.
