Mutual Funds vs. ETFs: A Comprehensive Comparison
Two popular choices for long-term investing are mutual funds and exchange-traded funds (ETFs). Mutual funds have been around for much longer than ETFs but ETFs have rapidly grown in popularity. Which should you choose? Is there are better option? In this comprehensive comparison, we will delve into the differences between these two common investment vehicles to help you better understand what you own and the implications of each.
The 30,000 Foot View
The core function of mutual funds and ETF’s are the same: to provide a means by which investors with limited capital can obtain diversification in the markets.
Investment theory states that an investor can obtain diversification benefits once you own about 30 stocks. But if you are a smaller investor with $3,000 to invest, how can you gain proper diversification if Amazon (AMZN) is trading at over $3,500 per share, Chipotle (CMG) trades at over $1,400 per share, or Berkshire Hathaway (BRK-A) trades at over $427,000 per share (Prices as of 10/3/2023 and will be different by the time you read this)?
Enter pooled investments which is what mutual funds and ETFs are. With pooled investments, the investor with $3,000 combines their money with thousands of other small and large investors in a fund. The combined fund, with a much larger capital base, then goes out and buys stocks or bonds on behalf of the investors to obtain diversification.
One of the largest mutual funds out there is the Vanguard Total Stock Market Index (VTSAX) with over $1.3 trillion in assets. VTSAX seeks to own as nearly every publicly traded stock in the US from the largest companies to the smallest companies. It has over 4,000 stocks in the portfolio. Vanguard also has an ETF (VTI) that seeks to own the exact same stock in the exact same percentage as VTSAX.
If an investor places $3,000 in VTSAX and $3,000 in VTI, for the most part, their gross investment returns will be exactly the same.
This is true of all mutual funds, exchange traded funds, and other pooled investments like annuity sub-accounts. Funds buy a wide range of investments on behalf of the investors and pass along the returns.
The investments that can be owned by mutual funds and exchange traded funds are also the same in that both can own stocks, bonds, cash, and commodities.
Of course, there are differences as explained next so read on.
The Nitty Gritty
There are a few main areas where mutual funds differ the most from ETF’s:
Passive vs Active
For the most part, investing in an ETF means you are investing in a passive investment strategy. This may be tracking an index or a rules based algorithm such as selecting dividend paying stocks. Actively managed ETFs have been released and more companies are looking into converting their mutual fund strategies into ETFs.
Mutual funds can be actively managed or passively managed. Actively managed funds utilize an investment team to choose the portfolio positions based on research and analysis.
Price of the Fund
Mutual funds are bought and sold at the total value of the underlying positions at the end of the day. In theory, this means you are always buying or selling at what the portfolio is worth.
ETF’s are traded on exchanges which means the price you pay can deviate from the value of the underlying portfolio which results in a premium or discount. In most large ETFs this is relatively minimal but it can be more of an impact on smaller ETFs or in less efficient markets like emerging markets.
When the Fund is Traded
Mutual funds are only traded once at the end of the day. This means that if you place a sell order at 11:30 AM EST for a mutual fund, the sell will not occur until 4:00PM EST at whatever price the Net Asset Value (NAV) is at the end of the day. ETFs trade intra-day which means that same sell order would happen at 11:30 AM at whatever the price the ETF is trading at.
Costs
Because most ETFs are passively managed, the overall average cost of ETFs is generally lower than Mutual Funds. Of course this can vary depending on the strategy being implemented and the market the ETF is focused in. For example, a fund that tracks the S&P 500 is going to have a lower expense ratio than a fund that invests in small emerging markets.
As of now, ETFs also trade for free at most institutions. Mutual funds may or may not carry a transaction fee ranging up to $50 per trade.
Share Classes
Share classes are effectively the same investment fund but with different fee structures. ETF’s are what they are and don’t have share classes making investing simpler.
Mutual Funds on the other hand can have a dizzying number of share classes (up to 14 on some funds). Some share classes are geared towards individual investors, some for investors working with advisors, some for retirement plans, annuities, and more. Each has it’s own set of higher or lower ongoing fees, sales charges, redemption fees, 12b1 charges, and more.
Minimum Investment
The minimum investment for an ETF is generally 1 share though some ETFs can be bought in fractional shares making the minimum investment even lower. Mutual funds minimum investment can range from zero to up to $1,000,000 for institutional shares.
Tax Efficiency (For Taxable Accounts)
In a mutual fund, when an investor places more money with the fund or withdraws money from the fund, the managers have to buy or sell positions in the underlying portfolio resulting in capital gains or losses. Similarly, the trading of the underlying portfolio by the managers results in capital gains or losses. These capital gains and losses are passed on to the investors of the fund annually, even if the investor did nothing but hold the position. This can result in distributions of taxable capital gains even when your position value has not changed.
ETF’s have greater tax efficiency because of the underlying process of maintaining the portfolio limits regular taxation to when the investor decides to sell and not when the mutual fund decides to buy or sell.
For more on this, check out: Understanding Estimated Capital Gains Distributions – Gilbert Wealth and How to Maximize the Tax Efficiency of ETFs | Morningstar
It is important to note that this is really only a consideration if the account is taxable. IRA’s and retirement plans like 401k’s do not have to worry about capital gains distributions as they don’t pay taxes until money is drawn from the account.
Summary
The decision between mutual funds and ETFs is not one-size-fits-all. Your unique financial situation and retirement goals will play a significant role in determining the right investment vehicle for you. As your trusted advisor, I’m here to provide guidance and assist you in making well-informed choices that will set you on the path to a secure and prosperous retirement.
Definitions
Net Asset Value (NAV): The underlying value of all of the positions within a fund at a particular time.