Investors face an ever-expanding array of investment options, and it’s important to understand basic distinctions between types of investment vehicles before making a choice.
Mutual funds and ETFs are similar in that in that they are pooled investments offering investors a convenient means of diversification with a single investment containing shares or fractions of shares from hundreds to thousands of different companies. That is a valuable offering for the average investor, who cannot afford to purchase troves of individual shares.
Just a quick note: Some sources indicate that ETFs are a type of mutual fund, but others refer to them as distinct from mutual funds, which is confusing. I’m treating them as their own creature entirely.
While mutual funds have been a longstanding fixture of the investment world, ETFs came onto the scene in 1993.
Each type of fund has unique advantages and disadvantages to consider in making an informed investing decision.
There are both passive (index) and active mutual and exchange-traded funds.
Actively managed funds comprise about 70% of funds. However, an increasing amount of capital has been flowing into passively managed funds: In 2011, passive funds received $140 billion more than their active counterparts. In 2015, that number jumped to $576 billion.
For the first 15 years following the first U.S. ETF company’s Securities and Exchange Commission (SEC) approval in 1993, ETFs were exclusively passive investment vehicles. But in 2008, the SEC approved the usage of actively managed ETFs. They’re still rare, having comprised just 1% of ETFs in 2015.
Trading and Pricing
Net asset value (NAV) is the per-share value of a mutual fund or ETF, and is based on the total value of assets (including stocks, bonds, cash, and other securities) in its portfolio less any liabilities (such as the manager’s salary and operating expenses) it may have, the total of which is divided the number of shares outstanding (the total amount of shares being held by shareholders). It provides a good picture of a fund’s per-share fair market price.
Mutual and exchange-traded funds’ NAV is updated once per day, following the closure of markets at 4:00 p.m. ET.
However, in the case of ETFs, an expected NAV (called the intraday NAV [iNAV], the intraday indicative value (IIV), or intraday operative value [IOPV]) is also calculated every 15 seconds.
Another difference between mutual funds and ETFs is that, like stocks, ETF’s prices (their market price) fluctuate throughout market day; investors can buy and sell at a premium (for a cost higher than the NAV) or at a discount (for a cost less than the NAV). This deviation from the NAV is known as the bid-ask spread. The bid-ask spread is the amount by which the ask price (the market price at which investors are willing to sell securities) exceeds the bid price (the market price at which investors are willing to purchase securities). For retail investors, it’s usually under a nickel per share. Bid-ask spreads are more prominent in the case of thinly-traded/low-volume securities, while more inconsequential in the case of highly liquid securities (those whose price is resilient to the effects of buying and selling) because buyers and sellers are in greater agreement over what prices should be. By contrast, bid/ask spreads are inapplicable in the case of mutual funds since they are only priced once a day (after the market closes) and trade at the net asset value, meaning there is no fluctuation in price throughout the trading day.
Reinvestment of Dividends
A shortcoming of ETFs is the hurdles for reinvestment of dividends. First, it takes a minimum of four days for dividends to be able to reinvested. Then, ETF holders must purchase new shares on the open market, which can be costly and risky due to market volatility, bid-ask spreads, and premiums/discounts add cost. Mutual fund holders, on the other hand, can simply reinvest their distributions at the net asset value on the ex-dividend date. This discrepancy is attributed to the fact mutual funds keep their own records while ETFs enlist brokerage firms to track fund ownership.
Both mutual funds and ETFs require tax payment on capital gains and dividend income.
However, the creation and redemption process for ETFs is such that ETFs are more tax efficient.
When an investor wants to redeem ETF shares, they transact directly with other investors, independently from the ETF. Thus, the tax implications of selling shares are felt only by those doing the selling. By contrast, when investors redeem shares of a mutual fund, the fund sells securities to raise cash and meet the redemption, incurring capital gains taxes. Those capital gains taxes are distributed equally among fund holders.
With ETFs taxes are usually incurred only at two points: upon receiving a dividend and upon selling the entire investment.
Due to the passive construction of most ETFs, there is little turnover; less buying and selling translates to less opportunities for capital gains to be charged.
Because of ETFs’ “in-kind redemption” feature, no or a negligible amount of taxes is incurred until the ETF holder sells the fund.
Further, when an AP seeks to redeem shares with an ETF, the fund normally doesn’t sell securities to pay them with cash. Insted, it provides them with the ETF’s actual underlying securities, selecting shares that were purchased at the lowest possible cost basis in order to minimize the potential for capital gains taxation later.
Fixed-income (bond) ETFs are an exception, as they often have high turnover and cash-based creation and redemptions.
Exchange-traded funds, or ETFs, are relatively accessible options for those without a lot of capital to invest, as they can be purchased for the price of a single share. How much does an ETF share cost? As I write this, among Vanguard’s 13 international ETFs, prices range from about $39–$100. Their 17 stock ETFs range from about $70–$218.
On the other hand, mutual funds typically have investment minimums of at least a few thousand dollars.
For example, two of Vanguard’s four share classes are Investor Shares and Admiral Shares (the other two are ETF Shares and Institutional Shares). Their Admiral Shares have lower expense ratios, specifically, over 52% lower than their Investor Shares. According to Vanguard’s mutual funds fees page, their Investor Shares class minimum is $3,000. For its Admiral Shares class of index mutual funds, the minimum is usually $10,000, while the minimum for admiral shares of actively managed mutual funds are usually $50,000.
ETFs have the benefit or transparency on their side. While mutual funds are only required by the Securities and Exchange Commission (SEC) to report their portfolio at the end of each fiscal quarter, ETFs disclose their portfolio holdings on a daily basis, available at no cost to the public.